Research Article focuses on the analysis and resolution of managerial issues based on analytical and empirical studies. Takeover Announcements, Open Offers, and Shareholders Returns in Target Firms Ajay Pandey

Introduction Post liberalization, Indian corporate world has witnessed several mergers and takeovers. Since corporate gover-nance in India,-in terms of enabling legal tod economic

institutions, is considered weak,1 it is worth its white to study the stock price performance of target firms in the context of change in management control. Empirical evidence in the context of developed countries supports the analysis that takeovers and other forms of plays, such as mergers and proxy contests, in the market for corporate control enhance the target firm's valuation by either exploiting synergies between target and bidder firm or by disciplining target firm's managers.2 Even though hostile takeovers are relatively uncommon outside UK and US due to political opposition, they are often viewed as an important, though imperfect, mechanism in mitigating governance problem for the investors.3 Shleifer and Vishny (1997) argued and challenged the effectiveness of takeovers in improving corporate governance, particularly in weak governance context. According to them, active takeover market can increase the private benefit of control for the managers. If the same basic idea is modified in the Indian (finance without governance) context, wherein the firms are usually controlled by owner-mangers (called promoters) with relatively high ownership4 stakes, it implies that takeovers and private valuation by the bidders may be based on their expected private benefit of control. If this were true, the open offers would be viewed favourably by the capital market but not because of any positive economic effect expected from the change in management or firms' economic prospects.

1 See relative ranking of India in a cross-country study by Demirguc- Kunt and Maksimovic (1998). 2 See Jensen and Ruback (1983) for an early review of empirical research in US. 3 See Shleifer and Vishny (1997) for review of research as well as a discussion on effectiveness of takeovers in resolving corporate governance problems between insiders and outsiders by allowing concentration of ownership. 4 In fact, the securities' market regulator (SEBI) and the financial institutions require that promoters need to have certain threshold stakes in the firm.

Vol. 26, No. 3, July-September 2001 19 Vikalpa

The empirical studies in the context ofdeveloped countries have consistently pointedout substantial valuation gains for target firms,particularly in case of successful takeovers.This effect has been "found to be higher fortender offers compared to mergers and proxycontests, the other forms of plays in the marketfor corporate control. Subsequent to enactmentof takeover enabling regulations in 1997 inIndia, takeovers and substantial acquisition ofshares necessitate making open offer to theinvestors. Based on the empirical investigationof 14 large (above Rs 10 crore) takeover relatedopen offers using event study methodology, wedocument significant announcement effect (10%) associated with the takeovers in Indiancapital market. We also find that the target firmvaluations increase in the runup toannouncement. However, unlike developedcountries, substantial part of these gains arewiped out subsequently indicating thatvaluation gains associated with takeovers inlarge part reflect private value of control,expected to be high in the Indian context Thefact that only one large open offer (out of 16in all) was associated with an attemptedunsuccessful hostile takeover bid suggests thatgiven relatively large insiders' shareholdings,takeovers as governance mechanisms are notlikely to be effective and private value ofcontrol may be the driver in the market for

t t l

Ajay Pandey is a member of the faculty in theFinance Area of the Indian Institute ofManagement, Ahmedabad. e-mail:Apandey@nmahd.ernet.in

The market, by reacting favourably, would be simply responding to a transitory opportunity to extract some part of the value associated with the acquirer's expected private value of control through arbitrage. This paper presents a study of relatively large target firms' price performance surrounding open offers in the context of change in management.

The primary motivation for the study was to test whether takeovers are seen by the capital market as creating value to the firm by improving performance as a consequence of change in management or as mere replacement of existing management without any expectation of concomitant improved managerial and firm performance. The latter argument, as outlined earlier, implies that takeovers are driven by private benefit of control and even if the market values such target firm at a higher level during the takeover process, if is merely due to the fact that some part of the private value of control can be shared due to mandatory open offer at a price, which is a reflection of existing and potential private benefit of control.5 This line of analysis, therefore, implies that the higher valuation of target firms will not persist once the process of change in control is over.

Takeover Regulations in India Till 1994, a suitable regulatory framework to facilitate takeovers in India through tender or open offer did not exist. Besides lack of enabling framework, relatively large inside holdings (direct as well indirect) and passive role played by the financial institutional investors (thereby, helping incumbents) were some of the other reasons for lack of takeover activity in the Indian capital markets. Except for clause 40 of listing agreement, the minority outside shareholders (and hence market) did not come upto play until were not protected in the context of takeover or substantial acquisition of shares. Clause 40 of the listing agreement stipulated that anyone acquiring more than 10 per cent (25% till 1990) voting rights/shares will have to make an open offer to other shareholders for a minimum of additional 20 per cent shares. This stipulation was very weak as it was based on shareholding and not on control. In the Indian context, it was and is possible to control a firm indirectly through cross-holdings. In 1994, the Securities and Exchange Board of Indra (SEBI), the capital market

5 If tfie shares are acquired from the market at low prices, they reflect the existing private benefit of control as imputed by the market. In such case, the incumbent is also likely to contest the bid by giving a counter offer. If, however, the shares are acquired from the incumbents through bilateral negotiations, they are based on prices reflecting the value of control to both incumbent and bidder.

regulator, came out with regulations oh takeovers and substantial acquisition for the first time. The new regulation warranted that anyone acquiring more than 10 per cent of voting rights in a company needed to make an open offer to buy-out a minimum of additional 20 per cent shares or voting rights, which reflected the prevalent clause 40 of the listing agreement for listed companies. By formalizing the same, the SEBI regu-lations widened its applicability and improved its enforceability. As the regulations of 1994 gave rise to severe problems of interpretation, SEBI appointed a committee headed by Justice PN Bhagwati in 1995. The report of this committee was submitted in January 1997 and SEBI reformulated its regulations and notified it by February 1997. Later, they were modified in 1998 to change the threshold level of acquisition triggering open offer from 10 per cent to 15 per cent and creeping consolidation limit from 2 per cent per year to 5 per cent per year. The takeover regulations by SEBI in 1997, thus, mark the beginning of an era in which takeovers and substantial acquisition of shares in firms are covered by regulations, which force the contestants in market for corporate control to share some part of the private value of control with outsiders. The post-1997 period also facilitates research in this area, as the information related to the open offers is available in public domain.

Takeovers and Market for Corporate Control

The interest in the influence of market for corporate control on the firms started with the seminal article of Manne (1965), in which he viewed takeovers and market for corporate control as mechanisms to check mana-gerial discretion conflicting with the shareholders' objective of wealth maximization. With the explicit characterization of firm as nexus of contracts and recognition of "principal-agent" problem embedded in the context of separation between ownership and control [term used later by Shleifer and Vishny (1997) is separation between Finance and Management], the agency- theoretic view of firm developed by Jensen and Meckh'ng (1976) linked the literature on market for corporate control with that of corporate finance. The agency costs due to conflict of interest between share-holders and managers are not borne completely by ' shareholders themselves, but also by managers and insiders through lower salaries (Fama, 1980) and lower valuation of the firm (Jensen and Meckling, 1976) to the extent the conflict of interest between managers or insiders manifests itself or is anticipated by the outsiders. As argued by Jensen and Ruback (1983), the efficacy of internal control systems to align the managers' interest with that of shareholders is contingent on the costs

Vol. 26, No. 3, July-September 2001 20 Vikalpa

associated with designing a system which measure managerial deviations from the shareholders' wealth maximization and are not expected to be trivial.6 The presence and extent of agency costs itself has been documented through empirical research across countries and has been comprehensively reviewed by Shleifer and Vishny (1997) in their seminal paper on corporate governance. The empirical evidence in the form of event studies has been consistent with the presence of significant agency costs. The event studies in US find negative returns associated with investment announce-ments by oil firms (McConell and Muscarella, 1986) consistent with Jensen's (1986) argument that managers prefer to reinvest cash over returning it to investors. Other event studies have found negative returns for bidders on acquisition announcement (Lewellen et al, 1985; Roll, 1986), negative returns on announcement of anti-takeover provisions (DeAngelo and Rice, 1983; Jarrell and Poulsen, 1988), positive returns on sudden deaths of entrenched and powerful managers (Johnson et a/., 1985). Similarly, empirical studies have also found evidence-of negative effect of diversification on share-holders' wealth (Bhagat, Shleifer and Vishny, 1990; Lang and Stulz, 1994; Comment and Jarrell, 1995), poor history of diversification by US firms (Kaplan and Weisbach, 1992), etc. These evidences are consistent with the presence of agency costs due to private benefits of control and are further corroborated with evidence of marginally higher prices of shares with superior voting 'right (Lease, McConell and Mikkelson, 1I983,19&4; DeAngelo and DeAngelo, 1985; and Zingales, 1995) and the rise of this premium in case bf contest for control (Zingales, 1995).

According to the agency-theoretic view of firm, the market for corporate control manifests itself through competition among "alternative management teams for rights tp manage corporate resources" (Jensen and Ruback, 1983) and is seen as external control mecha-nism limiting managers' arena to take decisions, which are pace inconsistent with that of shareholders' interest. In the market for corporate control, the competing managerial teams use different instruments, such as tender offers, mergers, and proxy contests, to acquire the rights to manage corporate resources. The market for corporate control allows aggregation of ownership and along with it intemalization of potential costs and benefits to the bidding managerial team. Otherwise, the externality of "free-riding by other widely dispersed investors" is recognized as a major deterrent to competition in market for corporate control. While the free-rider problem does get reduced in the market for corporate control to some

'See footnote 27 of Jensen and Ruback (1983).

extent, free-riding by the existing shareholders by holding out makes takeover costly for the bidder (Grossman and Hart, 1980). Given the complex nature of problems like information asymmetry, design of appropriate internal control and compensation system, and monitoring costs in the face of incomplete contract the investors have with managers or insiders, market for corporate control is seen as are important though imperfect control mechanism to limit managerial dis-cretion (Jensen, 1988; Scharfstein, 1988). It can solve free cash flow problem by distributing them to share-holders (Jensen, 1986,1988) and may be the only effective governance mechanism if internal controls fail (Jensen, 1993).

The empirical evidence in the form of event studies unequivocally points out that the target firms' valuations increase substantially in takeovers. Some of the early event studies by Mandelker (1974), Ellert (1976), and Langetieg (1978) on takeovers used the effective date of approval as the event date. The first study on takeovers recognizing the announcement date as event date is believed to be by Dodd and Ruback (1977) who find excess return of approximately 20.5 per cent and 19 per cent for successful and unsuccessful tender offers respectively, hi the announcement month. Their sample consisted of offers between 1958-1978 period. Similar event studies by Kummer and Hoffmeister (1978), Bradley (1980)Jarrell and Bradley (1980), and Bradley, Desai and Kim (1982) document 16-34 per cent excess returns around announcement date or month using different sample periods. Jensen and Ruback (1983:), while reviewing these studies, conclude that shareholder returns for targets in both successful and unsuccessful takeover bids are significant and the estimates could be downward biased in some studies as half of the price adjustment takes place prior to public announcement (Keown and Pinkerton, 1981). Later, Jarrell, Brickley and Nelter (1988) analysing 663 successful tender offers between 1962 and December 1985 report average excess returns of 19 per cent during 60s, 35 per cent in 70s, arid 30 per cent between 1980-85. They point out that these returns understate total gains to target firms' shareholders as the stock prices go up for these companies much prior to announcement of tender offers. Bradley, Desai and Kim (1988) similarly report significant gains for target firms' shareholders across different time-periods based on their analysis of stock returns associated with 236 successful tender offers between July 1963-December 1984. The empirical evidence across studies overwhelmingly points out to significant gains for target firms' shareholders though the evidence for gains to the bidder firms' shareholders is mixed, ranging from negative (Roll, 1986) to low

21 Vikalpa Vol 26, No. 3, July-September 2001

positive for successful takeovers7 (Jensen and Ruback, 1988). Evidence also exists for the disciplinary effect of takeover, as the incumbents are more likely to be removed after a takeover (Martin and McConnell, 1991) and Ihe taken over firms are more likely to be poorly performing firms (Palepu, 1986).

Despite widely accepted view of takeovers as an important, though imperfect, governance mechanism, Shleifer and Visfany (1997) questioned the effectiveness of takeovers as governance mechanism. In addition to free-rider problem making takeovers costly for bidders (Grossman and Hart, 1980), they argue that takeovers require liquid capital markets to finance, which may not always exist or may not be there in all countries. They also point out mat takeovers rather than mitigating governance problems could increase them by helping insiders and managers to expand their empires, even by overpaying for the acquisitions. The fact that hostile takeovers invite political opposition and are prevalent only in the US and UK were also brought out by them 10 question their effectiveness. Besides these arguments, effectiveness of market for corporate control is also contingent on the concentration of ownership, as the effectiveness of hostile takeovers is limited if there is a single large block of voting rights (Stulz, 1988). Stulz (1988) shows that though the expected premium rises for any takeover bid with the increase in insiders' holdings, its probability reduces. It is clear that hostile takeover bid is impossible in the limiting case of more than SO per cent inside shareholding. Weston (1979) had already pointed out that the hostile takeovers of firms having more than 30 per cent single block of shares held by incumbents are rare.

In a context like India, where relatively large inside holdings are common in firms and where the other elements of corporate governance are allegedly weak, takeovers are expected through friendly change of control except lor a few firms, which may have relatively less inside holdings. The ownership pattern found in India is Kkely to reduce effectiveness of takeovers as governance mechanisms and, therefore, the capital markets are also expected to react differ-en

Table 1: Open Offers in India

Period Change in Control Substantial Acquisition Consolidation of Holdings Total April 1997-March 1998 20 13 10 43 April 1998-March 1999 April 1999-March 2000

29 43

12 23

25 9 66 75

April 2000-March 2001 70 2 5 77 April 2001 4 1 2 7 Total 166 51 51 268

Source: Securities and Exchange Board of India, data on takeovers at web-site, www.sebi.com.

Table 2: Large Open Offers Associated with Change in Control (Sample of the Study)

No Target Firm Bidder Offer Price (Rs) Offer Period

i Gujarat Gas British Gas 270 14* Aug. 97- 13* Sept. 97 2. Wimco Swedish Match 35 9* Feb.98- 11* Mar.98 3. Merind Wockhardt 260 29th Apr,98- 28* May.98 4. BFL Software Barings India 135 9th May. 98- 8* June 98 S. Modi Xerox Xerox 150 17* June 99- 16* July 99 6. Autolec Industries Sundaram Fast 82.50 23rd July 99- 21* Aug. 99 * Albright and Wilson ISPG 240 26* Oct. 99- 24th Nov. 99 8. DLF Cement Guj. Ambuja 13.85 19* Jan. 00- 17th Feb. 00 9. Coates of India Sun Chemical 165 21* Feb. 00- 21" Mar. 00 10. Indian Aluminium Hindalco 190 26* May 00- 24th June 00 11, Superior Air Products Inox Air 81.20 5* June 00- 4th July 00 12. BSES Reliance 234.60 17th June 00- 16* July 00 B. Steelage Industries Gummenbo 272 23rd Oct. 00- 21* Nov. 00 I4>. GESCO Corp. Renaissance

Mahindra/Sheths 27/ 44

24* Nov. 00- 24* Jan. 01 26* Dec. 00- 24* Jan. 01

15. Com Products/ Hindustan Lever 173 27* Nov.OO- 26* Dec. 00 International Best Food 16. Rhone Poulenc Nicholas Piramal 875 6* Feb. 01- 7* Mar. 01

Source: Securities and Exchange Board of India, data on takeovers at web-site, www.sebi.com.

Methodology We follow event study methodology to assess the impact of open offer announcements on target firms' stock returns, as has been the case with the empirical works Cited earlier. Using risk and market adjusted variant of event study methodology, we first estimate parameters of the following model (a. and (3., for each stock) by regressing individual daily stock returns on the market index over the estimation period:

Ri = i + i Rm ..... (1) where,

Ri daily returns on i* stock, calculated as natural log of price relative, and

Rm daily returns on market index

The estimation period used was -51 days to -150 days (0 day being the open offer announcement day). The adjusted daily share price of the target firms was obtained from PROWESS (corporate database of Centre for Monitoring Indian Economy). The market index used for the market model is BSE Sensex (30 share value-weighted index of the stock _ exchange, Mumbai). The test-statistics for significance of excess daily return is given by:

Et / a (Et)

where, Et is average excess return on day t across the stocks and is given by:

Et = 1/N*( Ei,t)

Vol. 26, No. 3, July-September 2001 23 Vikalpa

Table 4A: Open Offers and Announcement Effect: Market-adjusted Excess Re-turns (Non-trading Days as Missing Data, N-14)

Period Excess Returns (%) t-statistus

0 to +5 Days -1.70697 -0.573774

Day 0 4.69415 3.528237 -1 to Day 0 7.85527 4.174912 -2 to Day 0 10.54271 4.575019 -5 to Day 0 12.62987 4.245364 -10 to Day 0 16.8189 3.997585 -30 to Day 0 30.3287 4.161929

Table 4B: Open Offers d

AnnouncemenEffect: Market-adjusted Excess Re-turns (Index Returns Adjusted for Corresponding Returns, N-14)

Period Excess Returns (%) t-statistics

0 to +5 days -2.04210 -0.663787

Day 0 4.47180 3.250267

-1 to Day 0 7.43071 3.819019

-2 to Day 0 10.1182 4.245972

-5 to Day 0 12.1668 3.954845 -10 to Day 0 16.3905 3.767292

-30 to Day 0 28.3813 3.766246

days. Looking at the raw data, it was apparent that particularly after open offer period, the trading in the stocks becomes infrequent, as there were large number of non-trading days in the data set. Ignoring the returns between successive trading days results in information loss. This is apparent from the behaviour of CAR in the two charts. While in Chart 2A, the CAR indicates that the target firms' stock returns stabilize after retracing some part of the gains earlier, Chart 2B based on returns across non-trading days indicates that most of the gains are wiped out after the offer period is over. This evidence is contrary to the stock price behaviour elsewhere, where most of the gains are found to be persisting. The result is also consistent with the argument that in absence of strong elements of other corporate governance mechanisms, takeover by itself cannot be effective and may be driven by the private value of benefits of control. The gains on such target firms' stock are transitory as the bidders in the corporate control market are forced to share some value with the other shareholders through open offers.

Vol. 26, No. 3, July-September 2001

Cumulative Average Excess Returns (CAR) around the Offer Closing Day The CAR plots in Charts 1, 2A, and 2B are around announcement day, with 0 day being announcement day. To analyse the returns behaviour around offer closing day, after which the transitory opportunity to sell at offer price to the acquirer ends, we calculated CAR between -10 to +60 trading days. The period chosen is immediately after the period in which market prices would be influenced by the offer price for acquisition. Chart 3 plots the CAR with 0 day being the offer closing day. As can be seen, the returns of these stocks continue to drift downwards, with maxi-mum drop immediately prior to the close of offer period. Discussion on the Literature The results discussed so far regarding post-announce-ment stock returns for target firms undergoing change of control in India are very different from the empirical evidence in the context of developed countries, as discussed earlier. They are also consistent with the critique of market for corporate control as an effective corporate governance mechanism by itself, unless supported by legal and economic institutions protecting outside investors. Our results are also different from that of Mohanty (2000), who studied 24 acquisitions in India during the period 1996 to 1997 and found positive excess returns up to 60 days for target firms. We think that -the difference in the results is mainly due to differences in regulatory regimes. SEBI takeover regulations came into force during 1997.This means that the sample of study by Mohanty includes firms which were taken over earlier. If the open offers are not necessary or are made at low-enough prices (after negotiating a large block purchase), then the returns behaviour would not be as observed. The amount by which the acquirers are forced to share their expected private benefits makes the difference to both the probability of acquisition as well as market valuation. The study by Mohanty has small and medium sized target firms as well, which we have not studied deliberately, as the premises of both capital market efficiency as well as economic rationality on the part of bidders are more likely to be violated for smaller transactions in market for corporate control.

One striking observation in our sample was that only one of the 16 large open offers made during the period was associated with contested control, i.e., GESCO Corporation. Even that bid failed as insiders and a white knight upped the offer and simultaneously bought over the bidder. All others were cases in which the control was transferred through bilateral negotiation between incumbents and bidders. It is hardly surprising

26 Vikalpa

Chart 3: Cumulative Average Excess Returns Around Offer Closing Day-Market-adjusted Returns

o

-0.25 J - Trading Days with Respect to "Offer Closing Day" that takeovers may not be disciplinary mechanisms in such a context. The market seems to think similarly.

It is possible to conjecture that market may view open offers associated with substantial acquisition dif-ferently as opposed to those associated with change in control, because it increases the possibility of contest later. The large open offers associated with substantial acquisitions are even fewer, but may shed some more light on the characteristics of market for corporate control in India.

Summary and Conclusions The corporate finance literature analysing takeovers argues that takeovers in particular and market for corporate control in general benefit the shareholders and society (Jensen, 1988). Empirical evidence has been consistent with the analysis. The arguments in the economic analysis of market for corporate control have been based on its disciplinary effect and optimal resource utilization through corporate restructuring facilitated by market for corporate control. On the other hand, some authors have pointed out weakness of market for corporate control as disciplinary mechanism. The free-rider problem faced by a potential bidder and presence of a single large block makes acquisition a costly proposition, reducing the effectiveness of market for corporate control. Similarly, market for corporate control may aggravate the governance problems, if private benefit of control rather than the potential

economic value of the firm is the driver of market for corporate control. This is a more likely scenario in weak governance context. It is, therefore, interesting to study post-announcement valuation effect in a context like India, where the corporate governance is considered weak.

Analysing daily stock returns of 14 target firms in which large open offers were made associated with change in control in India, we find that the announce-ment effect of the open offer (associated with change in control) is similar to studies from other countries. However, we find that post announcement, these gains are eroded substantially unlike the reported evidence from other countries. The results of our study are consistent with the argument that private value placed at control is quite high in such transaction and capital market does not place as high value on the firm. The findings also have implications for the Indian regulator (SEBI). Currently, the minimum size of open offers has been kept at 20 per cent of the aggregate shareholdings. The incumbents (industrial houses) have been demand-ing that the bidders should be forced to buy-out all the shareholders. From the governance perspective, either the control should vest with those who have very high stakes (direct, as otherwise control can be leveraged though partly owned and fully controlled entities) or very low stake. In case of former, the interests of insiders and outsiders are aligned naturally and in case of latter, the market for corporate control can be expected to

Vol. 26, No. 3, July-September 2001 28 Vikalpa

-005

-0 1

-015

be effective. Otherwise, market for corporate control cannot be expected to be very effective, similar to the result obtained by Sfculz, as discussed elsewhere in the paper. This reasoning supports the current relatively low open offer size if an overall cap is also prescribed. The other alternative of buying out all other shareholders, though sound from governance perspective, may make acquisition bid too costly to be an effective deterrent for incumbents.

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