2.7. Free-rider problem – solutions (1)

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Mergers and Acquisitions – The Relentless Pursuit of Synergy

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Moscow Institute of Physics and Technology

Mergers and Acquisitions – The Relentless Pursuit of Synergy

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Cours 4 sur 5 dans Specialization Understanding Modern Finance

The area of mergers and acquisitions (M&As) is special in finance. Incredible amounts of money are employed in such transactions. Deals draw a lot of public attention and dispute. Oftentimes, stories look more like fairy tales rather than financial reality. The key idea in any M&A transaction is to create value through a potentially synergetic activity. To this end, it is important to have a clear motive and implementation plan. Of special importance are the correct valuation, proper financing, and actual deal completion. But this is not the end – value mostly accrues from the post-merger integration. The understanding of the motives of various stakeholders is instrumental in the analysis of the potential creation of value. The learners will gain insight into the core value creating M&A strategies. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. Finally, the Course is very helpful in successful completion of the Specialization’s Final Project.

À partir de la leçon

Strategy and M&As. Theories of M&As

In Week 2 of the Course we discuss corporate strategy and its role in value creation. We revisit some well-known schools of strategic thinking and frameworks of strategy formulation and implementation. Our objective is to understand strategic motives behind M&A transactions. Equipped with the overall understanding of strategy, we proceed with the discussion of major theories of M&As – the motives behind the planned transactions that have the value creation potential. In all theories we try to reveal the actual interests of the key stakeholders. Finally, we study the actual deal mechanics and ways to overcome incumbent shareholder resistance (the free-rider problem).

2.1. Strategy – the art of the long view11:47

2.2. Strategic vocabulary – some approaches and frameworks7:43

2.3. Challenges to strategic planning8:07

2.4. Some well-known classic schools of strategy12:48

2.5. Theories of M&As (1)15:40

2.6. Theories of M&As (2)11:33

2.7. Free-rider problem – solutions (1)12:30

2.8. Free-rider problem – solutions (2)12:45

Rencontrer les enseignants

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Let's now talk about the free-rider problem.

This is a situation that is most often observed when tender offers are being implemented.

Now, what's the idea here?

Again, in plain words,

let's say I am the bidder and these are the shareholders of the targets.

And the circle of the target is rated at

a certain amount and I have a plan of how to make it higher.

Now, if I offered these shareholders

the amount that I am about to reach, then I lose money.

So, I will offer them something less than that,

higher than the prices are up right now so I do offer a premium.

But these people believe well,

wait a minute, he knows something.

He's offering us the amount that is clearly below the amount

that the stock will rise to if the offer succeeds.

Then if we stay out, if we hold,

if we don't tender or don't sell the stock,

then we're better off.

So, these people don't sell and the offer fails.

So, let me give you an example.

So, this is free-rider problem.

Well, let's say that there are

500 shareholders and the price of the stock of the target is $60.

Now, I'm the bidder so I have a plan

to reach $80 for

that and again the majority rule is imposed so if I buy 50 percent,

so 251 shares of stock,

then I'm fine I don't have to buy everything.

And let's say that B offers 70.

Now, will the target shareholders tender or sell the stock?

In order to answer this question,

we have to study their welfare.

So, how is that study.

We will say, well, there is a table so this is the action and again,

there are two outcomes.

This is that the offer succeeds and this is if the offer fails.

Again, there are two possible actions.

One action is tender so the shareholders do sell the stock and the other is hold,

so they just wait and see what happens.

Well, let's say that the offer is successful and you sold.

That means that you were offered,

so you get 70.

Now, if the offer fails, then well,

we study this simple case when we

see that even if it fails there is not a negative impact on that.

So, the stuff does not go below 60.

So, we stay with 60.

Now, if you hold however and the offer succeeds so someone else sold the stock.

So, you are among these 249 other people then you just sit with your stock,

wait until the bidder makes the company worth 80 bucks per share of stock.

So, your welfare is 18.

If the offer fails,

you stay with the same 60.

So, what is your dominant strategy?

Your dominant strategy is to hold because in this case,

regardless of where the offer succeeds or fails,

you get more and this or the same amount of money.

As a result, see what happens.

I make an offer of 70,

everyone holds and the offer fails.

Now, you can say, well,

the people should know this amount 80

because if for example I start bidding up 75, they still hold.

But if I offer 80, they become indifferent.

If I offer 81, they all sell the stock but in this case I lose money because

I paid higher than I expect to squeeze out from this company.

So, this is a classic situation and if

I do not send the signal that I have a plan to make it 80,

then the people are unwilling to sell.

Now, you can say if I offer them a premium,

why would some of them actually rush in and sell because they make an immediate profit?

Well, because these people are greedy and they say,

well, wait a minute,

there must be something in there.

So, we can see that this is a situation that is quite an obstacle

because you gave a premium and you still are not able to get control of this company.

What can be done?

Well, let's talk about solutions.

Solution one, and, well,

that's it's kind of strange

it's after tender dilution.

So, what do you do?

You openly say if I get control over that,

then you guys who just sit still and want to free ride on my actions,

you won't be able to do so.

Well, you may say that the minority shareholders because you have control,

they are sort of limited.

You can say, well, this is an abuse of that you might be sued against that.

Well, it all depends upon how you send the signal because

basically your idea is to make sure that these people will

sort of get scared and they'll rush in and sell to you.

Well, unless you do that openly illegally by open discrimination,

then you might succeed or you can say, well,

you will all have the same rights but when I get control,

I buy something important from this company at a lower price and by doing so,

I will effectively dilute your ownership.

I mean the value of your ownership will be lower.

Or I can sell something to the company that will be sort of very costly and as

a result again gas will go up and your ownership will lose value.

So, here we can say that there are various kinds of this limitation.

But now I want to study what goes on here.

I would say that there is the equivalent to that,

that is called a two-tier offer.

The idea is very simple.

I would say, well,

I will pay some amount up to 50 percent

of the stock and then if you are in the second cohort,

if you sort of lost your chance,

then I'll give you just a much smaller amount.

So, by doing so, I'm inducing everyone to rush in.

Well, if all of them come in then that will do it on a prorated basis.

Let me flip over the page and show to you how this goes.

So, this is the two-tier offer.

So, we have all the same story.

But now we'll have 10 shareholders,

and 10 shares, I'm sorry,

and then five shareholders.

So, two shares each and the price is 60 bucks as it was before.

Now, my offer is as follows. It's two-tier.

I say,, well, bidder is in blue here.

I say, I pay 70 up to five shares,

then I pay only $20.

Well, let's see what is the outcome.

Again, we create a table.

Now, the table is a little bit more cumbersome if you will.

So, here we have response to this offer,

and again there are two kinds of response tender so you sell the stock or hold.

Now, here there are basically the following outcomes.

Well, here the offer

fails and then you stay with your 120, right?

It's easy because you are with the same two shares of stock each at 60 bucks.

But it's more interesting what happens here if the offer succeeds.

Here, there are two outcomes so only five shares of stock are tendered.

Well, we say that if you get 50 percent draw, that's majority,

or all of them are tendered,

I will put that in blue.

In this case, this is a pro-rated situation. Let's see what happens.

If you sold and only five shares are sold,

then you are one of the first ones.

So, you have how much?

You have 70 at each of your two stocks.

So, this is 70 times two,

so you get 140.

Well, if all people rush,

then there is proration.

So, each one he has two shares of stock.

So, for your first share of stock,

you get 70, for your second one you get 20.

So, how much do you get?

You get 70 plus 20 which is 90.

If you hold however,

if the offer succeeds only five shares a tender then you are not in the first group,

then you have just 20 times two which is

40 and the same happens here 20 times two which is 40.

So, what's your dominant strategy?

Let's see. Now, it's all moved.

Now, your dominant strategy is to tender,

and if it's to tender everyone tenders and then we see this situation.

So, that's great because now the free-rider problem has been overcome.

The problem though is that before the welfare of

a shareholder was 120 and now it fell to 90.

So, this solution that is sort of pushy or scary,

it may lead to a successful transaction but unfortunately,

that results in the welfare erosion.

So, that is not great and people are not happy.

Maybe there are some other more efficient ways to overcome that.

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