How tighter laws can make takeovers work

Corporate chieftains in India often complain that the country's regulations governing mergers and acquisitions are too onerous. Clinching a takeover-cum-merger of a listed company, for instance, requires the acquirer to jump through multiple hoops — buying up a strategic stake from a bunch of stake owners, notifying the stock exchanges at the relevant ‘trigger' points, making sure public shareholders get an exit option through a tender offer, seeking shareholder approval for a merger and then waiting it out until the courts give their blessing to the union.

Large mergers have been stalled even after all these, on a stray shareholder petitioning the courts on ‘oppression of minority rights'.

Should there be so much legal protection for investors? After all, a thriving market for corporate takeovers does promote greater good, by re-allocating assets from weaker to stronger hands.

A paper by Mike Burkart, Denis Gromb, Holger Mueller and Fausto Panunzi on ‘ Legal investor protection and takeovers ' ( >http://www.nber.org/papers/w17010 ), argues that stronger legal investor protection is actually good for the takeover market and makes for a more efficient market for corporate control. It also finds that acquirers from countries with tighter investor protection have the edge over rivals, in cross-border takeovers.

Private benefits

The authors start with an explanation of how investor protection laws alter the standard takeover situation. When an acquirer makes a bid for a target, he does so in the hope that he will be able to derive significant value after the purchase. Now, the authors argue that those benefits can come in two forms.

One is the genuine increase in the company's value after the takeover through more efficiency, better practices or synergies — what is called value-unlocking in corporate parlance.

The second is the ‘private benefits' that an acquirer can extract from the target. This can be done through ‘semi-legal' means such as paying oneself an eight-figure salary, selling goods of the acquired company cheap to an owned firm or even diverting company assets to the private kitty of the new owner! Now, it is the extent of legal investor protection in a country that sets a limit to this siphoning off of value from an acquired company. The higher this legal protection, the less is the scope for such shenanigans.

Legal protection helps

Now, assuming that an acquirer is not simply sitting on a pile of cash while scouting for targets, he will have to approach a lender to fund his takeover plans. How much money he raises will directly depend on the legitimate value that he can create post-takeover, rather than on his ability to milk the company for ‘private' benefits.

This leads to the conclusion that a bidder who manages to create more legitimate value for investors is the one who is likely to find more financiers for his plans.

Where many bidders are in a race to buy a company, the one who can create more legitimate value is the one who can raise more funds and hence, win the bidding. That's why, the authors argue, stronger investor protection which limits ‘private benefits' after takeover, makes the market more efficient.

The authors build on this basic premise to arrive at other conclusions as well.

Tighter rules matter

One important finding is that, in cross-border takeovers, the nature of investor protection laws in the home country of the acquirer has a bearing on who can bid a higher price. Again, this is because the buyer with the tighter investor protection laws will be able to unlock more legitimate value from the target.

The paper concludes: “When bidders from different countries compete over a target, those from countries with stronger legal investor protection have a strategic advantage in the takeover contest.”

That should be good news for all those Indian business groups who have been beating a path to Africa and Latin America to buy up lucrative businesses.

In effect, what all this means is that, instead of complaining, India's corporate chieftains should actually be cheering on the government, as it adds to its bulky set of regulations and laws on investor protection.

Despite its indubitable logic, the main limitation to this paper arises from the fact that it is set in a perfect world where buyers as well as potential sellers act in a completely rational manner.

Hence the assumption that every acquirer has a fully accurate assessment of how much value he can create and pay the right price for the target. Or that shareholders drive a hard bargain to ensure that the acquirer coughs up full value for their shares.

In practice, the price that acquirers pay for fancied takeover targets can be wildly off the mark.

Not only can the buyer over-estimate his ability to create value, he could be helped in good measure by the whimsical valuation benchmarks provided by the stock market.

And what of takeovers which are fuelled more by the personal ambitions of the acquirer than by rational business considerations?

The model, for obvious reasons, does not factor in these idiosyncrasies of acquirers and sellers that make takeovers such a fallible device in the corporate world.

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