Successful vs. failed transactions: Are the looser of today the winner of tomorrow?

TABLE OF CONTENTS

LIST OF ABBREVIATIONS

1 INTRODUCTION
1.1 Problem definition and objectives
1.2 Course of analysis

2 BASIC TERMINOLOGY
2.1 Definition: The market for corporate control
2.2 Definition: Successful and unsuccessful transactions

3 ANALYSIS OF RESEARCH UP-TO-DATE
3.1 Reasons for value-enhancing takeovers
3.2 Motivations and forces that discipline managers
3.2.1 The realization of restructuring measures due to takeovers
3.2.2 The realization of restructuring measures due to takeover threats
3.2.3 The realization of restructuring measures due to other control mechanisms
3.3 Critical review of empirical evidence

4 CASE STUDY BANKERS TRUST AND DEUTSCHE BANK
4.1 Facts and Background Information
4.1.1 Bankers Trust ’ s acquisitions
4.1.2 Deutsche Bank - Bankers Trust Deal
4.2 Analysis of Stock Price Performance
4.2.1 Case Study Methodology
4.2.2 Stock price performances
4.2.3 Reasons for observed results
4.3 Case Study Results versus Academic Research

5 CONCLUSION

TABLE OF APPENDICES

BIBLIOGRAPHY

LIST OF ABBREVIATIONS

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1 INTRODUCTION

1.1 Problem definition and objectives

If the market for mergers and acquisitions is observed over the last few decades, it is quite impressive by what amounts the number and dollar volume of takeovers have increased year by year.¹ Although the rapid development has ceased over the past years, it is evident that mergers and acquisitions still play an important role in shaping the business landscape. In contrast, however, the benefits which are supposed to be generated by those takeovers are not that obvious. The topic of takeovers which turn out to be negative for shareholders is common and widely discussed in the financial business press. In spite of this fact, it is far less known what actually happens later on to those companies that realize one or more of these ‘bad’ acquisitions.

Observing these underperforming companies over time, it is disclosed that many of these ‘losers’ become takeover targets themselves afterwards.² Hence, it seems to be the case that the takeover of the value destructing company is related to or a consequence of the previously made transactions. If that holds true, then it could be the case that the takeover market serves as a means to discipline inefficient managers for their underper- formance.

In the light of this background, it is the aim of this paper to investigate the following two main questions:

1. To what extend can the takeover market help to discipline managers of firms that undertake value diminishing transactions?
2. If it turns out to be true that the takeover market has a disciplinary function, can some of the previously destructed value be regained afterwards?

The results gained will enable the reader to get a better understanding about some func- tions of the takeover market. Additionally the conclusions drawn can be used to give advice to company managers and directors, shareholder, and government regimes.

1.2 Course of analysis

In order to familiarize the reader with the basic terminology used throughout this paper and to avoid disaccords, the second part defines and explains the main terms. Once this foundation is laid out, the third part provides a detailed overview about existing theories that treat the subject of takeovers that discipline managers who made value diminishing transactions. Subsequently, the practical relevance of these theories will be tested by the use of empirical evidence. This analysis focuses on three main aspects: Firstly it is in- vestigated whether a realized takeover is useful to discipline management and to en- hance the company value of those targets. Secondly, it is tested to what extend the mere threat of a takeover can discipline managers. Thirdly, it is examined whether there are cases where other mechanisms - except the takeover market - might discipline manag- ers that undertake value destructing transactions. This structure is advantageous as it extends the analysis step by step and follows the development of the takeover market in a chronological order. In the final section of part three, the previous analysis of empiri- cal studies is critically reviewed and some limitations of their explanatory power are made.

The fourth part comprises a case study of the Deutsche Bank - Bankers Trust takeover in 1998 that illustrates exemplarily the importance and the consequences of a takeover that was carried out due to prior mismanagement of the target firm. The paper presents a detailed analysis of stock performance and background information in order to compare the findings with the prior presented overview of academic research. In its conclusion, the paper presents the key lessons learnt as well as implications for further research.

2 BASIC TERMINOLOGY

2.1 Definition: The market for corporate control

The takeover market can also be described as a market for corporate control. Corporate control is defined as “[…] the rights to determine the management of corporate re- sources - that is, the rights to hire, fire and set the compensation of top-level manag- ers”³. Consequently, the takeover market, or the market of corporate control “[…] is an arena in which alternative management teams compete for the rights to manage corpo- rate resources”⁴. If a company’s management team therefore is not capable to maximize the firm value, it loses its right to manage as soon as the company is taken over.⁵ Once this has happened, the current management can be replaced by a more efficient team. The market of corporate control can therefore help to ensure that managers handle the corporate resources in the interests of the company owners. This line of reasoning can also be described as “inefficient management hypothesis” or “disciplinary thesis”.⁶

The market of corporate control has two basic functions:⁷

1. Market Function - An efficient evaluation of the rights to manage corporate re- sources is guaranteed by the forces of supply and demand. Existing inefficien- cies in a company which are the result of mismanagement create incentives in form of value gaps for outside firms to take over control⁸ and restructure the firm. The realization of these restructuring measures can then lead to are reduc- tion of those value gaps and an increase company value.

2. Control Function - Managers are disciplined by other companies that act in the market for corporate control. The threat of becoming a takeover target incentives managers to minimize value gaps themselves, increase company value and act in the interest of shareholders.

2.2 Definition: Successful and unsuccessful transactions

An acquisition is realized if the acquiring company controls the target firm. Control is hereby defined as having a majority vote on the board of directors.⁹ Generally, acquisi- tions include mergers or consolidations, acquisition of stock and acquisition of assets. In this paper, a transaction - or precisely control transaction - is defined as an acquisition of one company by another.¹⁰ The term takeover will be used interchangeably with the terms transaction and acquisition.¹¹

Transactions can be classified with respect to their outcome into successful and unsuc- cessful transactions. A transaction is to be considered as successful if the company per- formance after the takeover bid announcement is higher than the company performance before the takeover bid announcement. A transaction is to be considered as failed if the company performance after the takeover bid announcement is lower than the company performance before the takeover bid announcement.¹² Generally, company performance is measured by the share price and can be determined in two different ways. In the first way the share price development is monitored over time and an increase in company performance is stated if the price is higher after the announcement date as compared to where it was before. In the second way, the development of the share price of the firm is measured relatively to the development of the share prices of a representative industry peer group or market index. If the relative development of the share price - also called abnormal return (AR) - has increased after the announcement date of the takeover, the corresponding result is a performance increase of the target and vice versa.¹³

Finally, it has to be determined in which time-frame around the announcement date the performance development is measured. It is thereby the aim to set the time window in such a way, that the share price movements which occur due to the takeover are iso- lated. Anyway, since this is a highly complex task, academic research uses several time windows in order to ensure its empirical significance. The exact duration and placement of the time windows used, however, vary across the different empirical studies. The most common periods used are as follows: [-1,1], [-5,1], [-5,40] and [-20,40], where the first number in the brackets determines the number of days prior to the takeover an- nouncement and the second number states the number of days after the takeover an- nouncement which are included in the event window.¹⁴ In the presented case study an- other event window of [-20,150] days is added to get additional insight about the longterm development of the firms’ performances.¹⁵

Generally it must be stated, that the share price turns out to be a very valuable measure of performance, as it includes the future expectations of shareholders about the development and success of the company. Some of the empirical research studies presented in the paper also use operating profit as a measure of performance.¹⁶ This measure, too, is directly linked with company performance. However, since it is based on past data, it might have slightly reduced explanatory power.

3 ANALYSIS OF RESEARCH UP-TO-DATE

After having set out the basic terminology and concepts of the study, the following part will explain the core theories and hypothesizes of this paper. Once the theoretical back- ground is laid out, a detailed overview of the research projects and journal articles that have already investigated the role of value diminishing and value enhancing takeovers will be presented.

3.1 Reasons for value-enhancing takeovers

The origins of the first theories about value enhancing takeovers can be found in the beginning of the 1960s. In a time where anti trust laws were quite rigid and where mergers and acquisitions were rather restricted in the United States, Donald Dewey raised objections against the policies that existed at that time and highlighted the eco- nomic benefits of takeovers.¹⁷ Dewey points out that a takeover as “a way of transfer- ring capital from one management to another”¹⁸ represents an effective alternative to bankruptcy for underperforming firms. This thought is then further developed by Henry Manne who claims that a “market for corporate control”¹⁹ exists. Manne bases his ar- gumentation on the fact that in general the share price performance of a company is interrelated with the efficiency of its management.²⁰ If a company performs poorly on the stock market due to management failure, its share price declines and drops below the price of comparable companies that employ more efficient management teams. As a consequence, the underperforming firm becomes a possible takeover target for other companies who believe that they can manage the target more efficiently. Once the firm is taken over, the underperforming management can be replaced by a more capable team which realizes those necessary restructuring measures²¹ that had been omitted so far and the overall company value can be enhanced.²² For this reason, the market of corporate control disciplines managers to act in the interests of their shareholders and mitigates the principal-agent conflict that might exist between these two groups.²³

The following paragraphs focus on one particular aspect of the market for corporate control: it will be critically examined in how far the takeover market is useful to disci- pline the management of companies which have made value destructing acquisitions before becoming a takeover target themselves. Additionally, the question will be raised whether some of the prior destructed value can be regained after the disciplinary take- over has been completed.

3.2 Motivations and forces that discipline managers

3.2.1 The realization of restructuring measures due to takeovers

This first part of the analysis focuses on companies that are actually taken over due to their prior value diminishing transactions.

First evidence for the validity of the hypothesis that underperforming acquirers become targets themselves is revealed in the research project of Mark Mitchell and Kenneth Lehn.²⁴ The study program investigates 1158 companies in 51 industries for the period of 1980 to 1988. The acquisitions which were announced between 1982 and 1986 revealed the following main results:²⁵

- Targets, especially targets of hostile takeovers had made systematically acquisi- tions that reduced their market value before they were taken over themselves. In contrast, non-target firms could increase their market value on average.
- The divesting rate of prior acquired business units was much higher for companies that were taken over themselves later on (40.7%) than it was for companies that were not taken over (9.1%).
- Especially those prior acquisitions that had led to strong share price declines were divested once the target was taken over.

These results seem to undermine the fact, that the market of mergers and acquisitions for corporate control disciplines inefficient management. Those companies that make value reducing acquisitions incur the risk of being bought themselves (control function of the market for corporate control).²⁶ Once the disciplinary takeover is realized, the high rates of divestiture indicate that the underperforming targets are restructured by the new management so that the company resources are allocated in a more efficient way (market function of the market for corporate control).²⁷

Support for the assumption that some of the value that has been destroyed previously can be recovered after the disciplinary takeover is given in the paper of Michael Jensen and Richard Ruback.²⁸ Analyzing thirteen field studies which have been carried about the wealth effects of takeovers, Jensen and Ruback are able to clearly state that “targets of successful takeover attempts realize substantial and statistically significant increases in their stock prices”.²⁹ In fact, the average abnormal return for targets of successful tender offers amounted to 29.1% during the takeover period.³⁰ The average abnormal return for successful mergers was less, but still reached up to 7.7% on average.³¹ It can therefore be concluded, that the market for corporate control can help to increase the value of companies. In the light of this result, takeovers lead to desirable outcomes for the companies and the whole economy.³²

The above findings and implications can also be looked at from a slightly different an- gle. The interesting question might be raised of what are the reasons for managers to undertake value diminishing transactions in the first place. In reality, it can be observed that the intentions of corporate managers might deviate from the interest of sharehold- ers. Whereas shareholders want the maximization of the value of their company, man- agers - although actually acting as shareholders’ agents - are often more keen on in- creasing company growth.³³ Instead of keeping the firm size at its optimal, value maxi- mizing level, management continues to expand further. Especially in companies which generate high amounts of free cash flow this problem is prevailing, as managers rather invest into unprofitable projects and make value diminishing acquisitions instead of returning excessive company surpluses to its shareholders.³⁴ In this case, once again the market for corporate control may help to discipline management. The wastage of re- sources can be stopped once the firm is taken over which leads to overall efficiency gains. Additionally, it is common to increase the payouts to shareholders and augment the level of leverage of those firms after the transaction. This measure ensures that man- agement cannot invest discretionally the cash flows of the firm in the future as fixed interest payments have to be made.³⁵ Consequently, the possibility of investing into low-return projects is limited.³⁶

Summarizing the results above, the hypothesis that today’s losers become winners in the future, seems to be confirmed. Companies that make value diminishing transactions get disciplined by the market of corporate control and previously lost value can partially be regained. Therefore, the market of corporate control helps to ensure that the agents of shareholders act in the company owners interests.

3.2.2 The realization of restructuring measures due to takeover threats

The previous part has analyzed to what extend takeovers can discipline managers who reduce company value by making unprofitable acquisitions. However, only those trans- actions were taken into account, where the disciplinary takeover was completely real- ized. In the light of the fact, that about 18.7% of takeover bids made between 1989 and 1995 were ultimately abandoned,³⁷ the current border of the study is rather limited. In this section, the analysis is extended and it is investigated whether the market of corpo- rate control also works if the target defeats the disciplinary takeover. In other words, the question is raised whether the mere takeover threat is sufficient to initiate the economi- cally desirable restructuring process. This means, that the corporate managers realize and recognize the necessary changes and carry them out themselves.

In fact, there are several empirical investigations which seem to prove that the above made hypothesis holds true. It can be observed, that “targets successfully resisting take- over bids undergo significant changes after the bid is abandoned”.³⁸ In his field research about successful and unsuccessful takeover bids, David Denis made the following ob- servations:³⁹

- When the takeover threat was defeated by the firm, cumulated abnormal returns (CARs) of 15.95% during the period of the control contest⁴⁰ were earned by share- holders on average. If the takeover was completely realized by a bidder, CARs av- eraged at 28.73%.
- If the takeover defeat was accompanied by a restructuring announcement of the current management, CARs amounted to 20.75%. Otherwise, CARs only reached 12.72%
- Defeated takeover threats are strongly related with restructuring measures that are initiated by the targets:
- Top Management Turnover⁴¹ - From the beginning of the pre-contest period until one year after the outcome, 35.1% of all companies underwent manage- rial turnover.
- Corporate Downsizing and Asset Restructuring - 29.7% of the targets laid off or early retired employees and 29.7% of sold off major company units.
- Changes in Capital - average leverage ratios increased from 21.0% in the pre- contest period to 42.6% in the post-outcome period.

The first point of the results clearly shows that shareholder value is increased even if the takeover threat is defeated as almost 16 percent of abnormal return is generated on aver- age during the bidding period. The second point undermines the previously made as- sumption that the increase in share price is due to the initiation of disciplining restruc- turing measures, as the firm’s CARs are much higher if they are accompanied by a re- structuring announcement. These restructuring measures include the change of part of the top management, corporate downsizing, asset restructuring and changes in capital. Especially the high percentages of downsizing and asset restructuring of almost 30 per- cent indicate that the errors of previously undertaken value diminishing transactions are corrected. Also the increase in debt is to be interpreted as a positive disciplinary result of the market of corporate control, because leverage “[…] commits managers to making the improvements that would be made by potential raiders”.⁴² This finding is in line with the results of the previous part where it was shown that companies making bad acquisitions with excess cash flow get levered once they are taken over.⁴³

The empirical results demonstrate that the market for corporate control also can work if the disciplinary takeover is not realized.⁴⁴ However, there is one important aspect that has been omitted so far: the results of Denis’ research show that CARs are on average higher for those firms where the takeover is realized in comparison to those firms that defeat the takeover (15.95% and 28.73% respectively).⁴⁵ The result seems to be surpris- ing at first sight. In fact, evidence exists that there are several cases, where the mere takeover threat is not as efficient to discipline management as the complete takeover. If managers deploy mechanisms such as anti-takeover amendments or standstill agreements,⁴⁶ they might succeed to insulate themselves from the disciplinary effects of the market for corporate control. Since those managers do not feel actually threatened by the takeover attempt, they are not actually forced to initiate restructuring processes to undo their previously made value diminishing transactions.⁴⁷

Summarizing this section it can be concluded that also the mere threat of a takeover is effective to discipline managers that have made value destructing transactions in the past. However, the potency of this market is reduced if the target management succeeds to insulate itself from the takeover threat. In order to maximize firm value and shareholder wealth companies should therefore ensure that the top management does not deploy such anti-takeover mechanisms.

3.2.3 The realization of restructuring measures due to other control mechanisms

It is common sense, that a takeover threat - especially a hostile one - is not a very convenient way for a company to learn that it has to correct managerial mismanagement. It is therefore desirable for a firm to identify and correct errors before a takeover threat comes up. Additionally, it must be stated that in the case of a disciplinary takeover company value is destructed prior to the corrective measure. For this reason it is economically desirable that firms solve management issues by the use of other governance regimes before big value losses are incurred and before the threat of a takeover comes up. In this sense, the market of corporate control can be seen as “a court of last resort”⁴⁸ if prior mechanisms to discipline managers have failed.

The measures for corporate control can be divided into internal and external measures.⁴⁹ Internal control mechanisms include mainly the surveillance of management by the board of directors and the competition and monitoring among managers, but also other governance structures, incentive systems for managers and a code of conduct.

[...]

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¹ See Appendix I.

² This assumption will be discussed more thoroughly in section 3.2. It relates to findings of the field study that was carried out by Mitchell and Lehn. See MITCHELL/LEHN (1990), p. 37.

³ JENSEN/RUBACK (1983), p. 2. The quotation is based on a previous work of Eugene Fama and Michael Jensen where the authors describe the role of the board of directors. See FAMA/JENSEN (1983), p. 14.

⁴ JENSEN/RUBACK (1983), p. 49.

⁵ The reason why companies whose share price is lower than it could be with a more efficient manage- ment team often becomes a takeover target is explained in detail in Part 3.2.

⁶ See KERSCHBAMER (1998), p. 266.

⁷ See GÜNTHER (1997), p. 34.

⁸ The phrase ‘taking over control’ is explicitly defined in section 2.2. The definition used in this paper deviates from the one of Günther. Whereas Günther refers to general rights of disposing in a firm, this paper focuses on complete company takeovers. See section 2.2 and GÜNTHER (1997), p. 34.

⁹ See ROSS/WESTERFIELD/JAFFE (2005), pp. 798f.

¹⁰ See Rock/Waghter (2003), p. 463.

¹¹ In fact, the term takeover is general and imprecise and refers to the transfer of control of a firm from one group of shareholders to another. Takeover can also include proxy contests and going private. However, the latter to forms will not be dealt with in this paper. See ROSS/WESTERFIELD/JAFFE (2005), pp. 798.

¹² Although this definition of successful and failed transactions is not explicitly made in the available literature, it is implicitly used in the research studies.

¹³ See exemplary JENSEN/RUBACK (1983), p. 4.

¹⁴ See MITCHELL/LEHN (1990), p. 383.

¹⁵ For further details concerning the latter time window, see part 4.2.1.

¹⁶ See for example AGRAWAL/JAFFE (2003), p. 728.

¹⁷ See DEWEY (1961), pp. 256f.

¹⁸ DEWEY (1961), p. 257.

¹⁹ MANNE (1965), p. 112.

²⁰ The interrelation between company performance and management efficiency is yet to be proved by empirical evidence. However, it exceeds the scope of the paper at this point and it is therefore assumed that the relationship holds true.

²¹ What exactly these restructuring measure are will be explicitly treated in section 3.2.

²² See MANNE (1965), pp. 111-113.

²³ The correlation between takeovers and diverging interests of shareholders and management is investi- gated in depth by Robin Marris. See MARRIS (1963), pp. 185-191.

²⁴ See MITCHELL/LEHN (1990), pp. 372-397.

²⁵ See MITCHELL/LEHN (1990), pp. 381-389; MITCHELL (1991), pp. 22f.

²⁶ See section 2.1.

²⁷ See section 2.1.

²⁸ See JENSEN/RUBACK (1983), pp. 6-22.

²⁹ JENSEN/RUBACK (1983), p. 8.

³⁰ The takeover period varies between the studies and ranges from one to two months surrounding the takeover bid. See JENSEN/RUBACK (1983), pp. 8-11.

³¹ See JENSEN/RUBACK (1983), pp. 8-11. The analysis of why differences between the returns of tender offers and mergers exist is explicitly analyzed and explained by Jensen and Ruback. However, it ex- ceeds the scope of this paper. The observation that over all an increase in returns of targets is realized is sufficient for the conclusions drawn at this point.

³² See MITCHELL (1991), p. 21.

³³ The reasons why managers often prefer company growth to value maximization are explicitly ad- dressed in principal-agent theories. One reason is that management wants to increase its power. Addi- tionally their wages often rise with company growth. Moreover managers can reduce business risk by increasing the size of the firm (especially when growth is aimed at diversification). For more detailed information about principal-agent conflicts, see FAMA (1980), pp. 288-307; JENSEN/MECKLING (1976), pp. 305-360; a good overview and assessment is given in EISENHARDT (1989), pp. 57-74.

³⁴ See JENSEN (1986), p. 323.

³⁵ The conclusion that cash-flow related takeovers lead to an increase in leverage is supported by a study of Robert Hendershott. Hendershott’s empirical results state that takeover targets use the increase in leverage as a defence mechanism to avoid the takeovers. Consequently these firms carry out the desir- able restructuring measurements themselves and thereby reduce the possible gains for the acquirer. See HENDERSHOTT (1996), pp. 563f.

³⁶ The measure of increasing debt after the takeover is not suitable for every company, however. Espe- cially those firms which are rapidly growing and have a lot of high-cash flow projects in which they can invest will not augment their debt level. Leveraging the firm is more relevant for companies that are in the mature or declining phase of their life-cycle. See JENSEN (1986), p. 324.

³⁷ See O’SULLIVAN/WONG (1998), pp. 93f.

³⁸ O’SULLIVAN/WONG (2001), p. 179.

³⁹ See DENIS (1990), pp. 1434-1452. The study comprises the years of 1980-1987. The sample of compa- nies includes firms that involved a repurchase of shares or special payout to shareholders subsequent to a takeover bid.

⁴⁰ The period of the control contest extends from 40 days prior to the initiation of the control contest through the contest outcome. See DENIS (1990), p. 1441.

⁴¹ Managerial turnover hereby is defined as a change in either the president, CEO or the chairman of the board; See DENIS (1990), p. 1448.

⁴² SAFIEDDINE/TITMAN (1999), p. 547.

⁴³ See part 4.2 and JENSEN (1986), pp. 323-325.

⁴⁴ See DENIS (1990), p. 1434. An illustrative example of a firm that made value diminishing acquisitions and subsequently initiated restructuring measures due to a takeover threat is presented by Mark Mitchell. The author describes the unsuccessful hostile takeover attempt of Goodyear by Goldsmith in October 1986. Due to a harsh restructuring program that included the divesting of several business units, Goodyear was finally able to defend itself remain independent and increase its share price. See MITCHELL (1991), p. 22.

⁴⁵ See DENIS (1990), p. 1441.

⁴⁶ See JENSEN/RUBACK (1983), pp. 38-45.

⁴⁷ See DEANGELO/RICE (1983), pp. 330-336.

⁴⁸ KINI/KRACAW/MIAN (2004), p. 1550.

⁴⁹ See DENIS/KRUSE (2000), p. 395.