Corporate Finance

• The downtrend in small firm profitability (not only IPOs) began before SOX (2002).
• Among small firm IPOs, the percentage that are unprofitable in the three years after going public has increased from 58% in 1980-2000 to 73% in 2001-2009. In contrast, for large company IPOs there has been no downtrend in post-IPO
• profitability.
• The long-run returns earned by investors on small company IPOs have been poor from 1980 to 2009, with the relative performance of small company IPOs particularly disappointing after 2000.
• Inconsistent with the regulatory overreach hypothesis, relatively few U.S. firms have chosen to go public abroad.
• For the firms that do go public, the fraction that are acquired or make acquisitions within a few years of going public has increased over time.

Underpricing compensates for risk (Ritter, 1984):
– Riskier IPOs will be underpriced by more than less-risky (information-asymmetry etc.) IPOs.
– If the proportion of IPOs that represent risky stocks increases, there should be greater average underpricing.
– Risk can reflect either technological or valuation uncertainty.
 

Realignment of incentives (Ljungqvist and Wilhelm, 2003):
– Managers are willing to leave money on the table, especially during the 1999-2000 period for the following reasons:  
- lower CEO ownership
- fewer IPOs containing secondary shares
- increased ownership fragmentation (one owner could bargain better than many)
- more “friends and family” share allocations

Analyst coverage and spinning (Loughran and Ritter, 2004):
– As issuers placed more importance on hiring a lead underwriter with a highly ranked (and bullish) analyst to cover the firm, they became less concerned about avoiding underwriters with a reputation for excessive underpricing. In the future, they would profit from that relationship and get shares in other IPOs.
– The more that issuing firms see analyst coverage as important, the more they are willing to pay these costs.
– Beginning in the 1990s, underwriters started to set up personal brokerage accounts for venture capitalists and the executives of issuing firms in order to allocate hot IPOs to them (“spinning”).
– The purpose of these side payments is to influence the issuer’s choice of lead underwriter: These payments create an incentive to seek, rather than avoid, underwriters with a reputation for severe underpricing. 

• IPO firms significantly underperform over the first year after going public, while there is virtually no underperformance thereafter.
• The finding of an IPO underperformance based on a Carhart type four-factor model contradicts prior research.
• These studies however focus on longer time horizons of usually three to five years over which the underperformance is in fact substantially weaker.
• When besides the four Carhart risk factors (market excess return, size factor, value/growth factor, and momentum factor) various firm characteristics related to the IPO market environment, firm leverage and liquidity, firm valuation,
• corporate diversification strategy, and investments are accounted for, there is no significant difference between the performance of IPO firms and that of nonissuing (mature) companies.
• As in the case of IPOs, there is a large literature documenting that stocks of common stock issuers (SEOs) subsequently underperform non-issuers which are matched based on size and book-to-market by approximately 40%-60% over 3 to 5 years (Loughran and Ritter, 1995; Spiess and Affleck-Graves, 1995).
• Using a sample of more than 7,000 seasoned equity (and debt) issues from 1964 to 1995, Eckbo, Masulis, and Norli (2000) document that issuer underperformance reflects lower systematic risk exposure for issuing firms
• relative to the matched firms.
• A consistent explanation is that, as equity issuers lower leverage, their exposures to unexpected inflation and default risks decrease, thus decreasing their stocks’ expected returns relative to matched firms.
• Equity issues also significantly increase stock liquidity (turnover), again lowering expected returns relative to non-issuers.
• Eckbo, Masulis, and Norli (2000): The “new issue puzzle” is explained by a failure of the matched-firm technique to provide a proper control for risk.

•  1960s: “conglomerate merger wave”
  • Aim was to acquire firms in unrelated businesses to become large conglomerates (big company with many unrelated activities) to diversify and reduce risk
    • But diversification is sth the shareholders can do on their own
• 1980s: hostile “bust-up” takeovers
  • Idea was not to build up a larger firm but to buy a competitor and sell the assets and use that money to pay for the acquisition price -> simply to get rid of a competitor
• 1990s: strategic/global mergers in related areas
  • Takeover as a mean to get access to international markets. If e.g. you are German, you can buy a Swiss firm to get access to the Swiss market

Economic reason for acquirer to pay so much for a target:

The target firm is unique and thus has a monopoly on the market. Accordingly, it sets the price way too high to maximize it's profits (VWL).

Further, the acquirer has to make an offer that seems reasonable to the current owners 'cause they might be aware of how much money the acquirer can make out of their shares. If the price isn't high enough, the owners of the target wouldn't be willing to sell the firm, they would wait

Most important success factor for MA strategies: Does the merger take place?

If it does not, all the gain will be lost! (Honeywell case)

• The position and conduct of the management of the target firm
• Potential anti-takeover measures put in place by the target firm's management (e.g., poison pills, shareholder rights plans, classified boards with staggered terms, etc.)
• The willingness of shareholders to sell their shares for the offered price
• The regulatory authorities (e.g., Federal Trade Commission (FTC) in the US, Weko (Wettbewerskommission) in Switzerland, Bundeskartellamt in Germany), you must be familiar with the law!

Additional risk factors

• A successful (diversified) implementation of MA strategies requires enough mergers
• “merger spreads” have to be large enough on average to be able to overcompensate the losses from failed transactions
• Merger waves: bear markets and an unstable economic environment negatively affect the number of announced transactions and the success probability

Poison Pill

A strategy used by corporations to discourage hostile takeovers. With a poison pill, the target company attempts to make its stock less attractive to the acquirer. There are two types of poison pills: 

1. A "flip-in" allows existing shareholders (except the acquirer) to buy more shares at a discount.
2. A "flip-over" allows stockholders to buy the acquirer's shares at a discounted price after the merger.

(Board with) staggered Terms

The board has people with different terms, thus the board cannot be replaced simulaneously

.

Those firms in which managers are protected do worse in a takeover

-> there might be a lot of personal and prestige reasons instead of value-maximization for the firm and the shareholders  (e.g. empire building or doing a merger in a field where manager is an expert so he won't be fired etc.)

picture: indices measure the anti-takeover provisions (the higher the index, the worse the corporate governance)

.

.

careful: the results of the McKinsey-survey are only statements, not measurement results!

Class focuses on the first two

remarks:

Threat of takeover: if you waste a lot of money your share price plummets and you're likely to be taken over and fired

High debt levels: without debt, you only "have to" pay dividends, but you can just as well use that money for corporate jets etc. Debt, on the other side, HAS to be paid back!

Greater pay for performance may align managerial interests with shareholders’:

• The larger the fraction of the equity of the firm the manager owns, the costlier the private consumption perks will be for her (ex-post).
• By making pay contingent on performance, the manager is more likely to be diligent and to take the right (NPV maximizing) projects (ex-ante).

Typically, one cannot observe managerial effort directly but by a noisy signal like profits. One has to make payments contingent on this measure.

Trade-off between risk aversion and provision of incentives: Making pay sensitive to profits provides incentives for the manager to exert more effort.

Limitation
However, since part of the profits is outside the control of the manager, you subject her pay to noise, and she will demand a higher expected pay even though she didn't do anything for it!

1. Incentive plans motivate managers to make better decisions
2. “Managers might have influence over their own compensation and use this power to obtain more performance-based pay in advance of anticipated stock price increases” (e.g., Yermack, 1997).
   • Managers can decide the starting point of an option -> they choose a low point before an increase so that the value of the option will increase
3. Backdating (e.g., Heron and Lie, 2007)
   • Even if you're already in the future, you can negotiate the starting point to be some time ago

.

Both cash and equity payments increased -> total compensation increased!

.

1. Classified board
2. Limitation on amending bylaws (Statuten)
3. Limitation on amending the charter ([Gründungs]urkunde)
4. Supermajority to approve a merger
5. Golden Parachute
6. Poison Pill

-> the more such things you have, the higher your index and the lower your value because the worse your corporate governance

• A common “reverse causation” story in the corporate governance literature is the possibility that a firm with lower firm valuation will tend to limit shareholder rights, adopting more G-Index provisions in order to insulate the firm from hostile takeovers (see, e.g., Lehn, Patro, and Zhao 2006).
  • As a result, the documented correlation between low firm valuation and the GIndex, according to this story, might be at least in part due to reverse causation.
• Cremers and Ferrell (2011) examine whether a firm’s valuation, as measured by that firm’s lagged Tobin’s Q ( Kurs-Substanzwert-Verhältnis handelt. Ein Wert kleiner 1 zeigt eine Unterbewertung, ein Wert größer 1 eine Überbewertung an), helps to explain changes in a firm’s G-Index and E-index scores (controlling also for other firm characteristics).
  • The results show that the explanatory power of lagged Q is relatively weak and economically minor indicating that the problem of reverse causality is unlikely to be responsible for the positive relation between governance and firm value

-> As the effect of lagged Q on corporate governance is substantially smaller than the effect of corporate governance on Q, reverse causality is unlikely to be responsible for the significant negative relation between Q and governance.

• The year of the dramatic increase in the incidence of poison pills, 1985, was the same year as the seminal case of Moran v. Household International, which judicially validated the poison pill for the first time.
• Cremers and Ferrell (2011) test the hypothesis whether the legal validity of the poison pill after 1985 instigated a significant shift in power from shareholders to the board of directors.
  • As the use of the governance provisions in the G-Index is largely at the board’s discretion, this would imply that the G-Index, poison pills, and classified boards have a more significant negative effect on firm valuation post-1985 relative to pre-1985
    • The governance provisions in the G-Index could affect the likelihood of receiving a successful takeover bid and thus a significant takeover premium.
    • If the G-Index is negatively associated with firm value by reducing the likelihood of an attractive takeover, then the negative effects of a higher G-Index should be particularly powerful when a firm happens to be in an industry experiencing “high” levels of takeover activity, relative to firms in the same industry with lower G-Index scores and relative to firms with the same G-Index score but in an industry which was experiencing “low” levels of takeover activity in that year.

-> As one can see on the picture: without the poison pills, the G-index is not significant anymore!

-> The poison pill is one of the most important ingredients of corporate governance (the results are mainly driven by it). If you have a poison pill, you cannot easily be taken over and thus can waste more money...

• Independent
• Mutually exclusive (you can EITHER do one or the other)
• Contingent (you can only do B if you do A first)

.

.

.

• complexity (start with small question -> model starts growing)
• size (large data)
• understanding of the problem (esp. as a consultant from the outside)
• potential impact (on course of company)
• urgency of results (you barely have enough time)
• people involved (many)

.

.

And for the Build Phase: KISS -> Keep It Smart and Simple

• Sensitivity (analyzes effects of changes in sales, costs etc. on project), e.g. Otoboai Scooter case
• Scenario (project analysis given particular combination of assumptions)
• Simulation (estimates probabilities of different outcomes)
• Break Even (level of sales [or other variable] at which project breaks even)

.

• Inside factor for profitability
• Systematic risk
• Overall risk (volatility) of a firm and the systematic risk of common stock of a firm are positively associated with the degree of operating leverage, or negatively associated with the firms level of variable costs

Implications: Capacity planning/forecasting is crucial!

.

.

.