Do Unto Yourself

Ralph’s suggestion to leave nothing on the table to reduce hostile takeover risk is a wise one. Hostile bids are a struggle by competing management groups over the control of corporate assets and strategies. Firms compete in two different markets. The first is the product market for customers and revenues. The second is in the capital markets for capital. Product market changes, such as new regulation, impact firm performance. It requires management and strategic adjustments. However, organizational inertia keeps management from changing strategies that have previously  been  successful. The delayed adjustment depresses returns on equity and equity values relative to underlying asset values. Furthermore, management continues to invest despite the unattractive returns believing the poor operating situation is only temporary, which worsens the problem. The depressed returns and weakening stock price attract bidders who believe they operate the firm more efficiently.

The key characteristics of takeover risk include

•  Fundamental structural change as opposed to cyclical industry change
•  ROE less than cost of equity
•  Sum of the parts exceeds the firm’s market value

Firms operating with these characteristics have two choices. Either adapt yourself or someone else will do it for you. A good example of this was provided by the 2007 takeover of ABN AMRO by a banking consortium of Royal Bank of Scotland (RBS), Banco Stantander (BST) and Fortis (FT). The trigger was an on-going war of words initiated by TCI (The Children’s Investment Fund) a UK hedge fund. TCI had been complaining of ABN’s subpar returns Also, TCI demanded in February, 2007, that bank management should consider a break up the bank as the sum of its parts was worth more that the bank’s current market value. TCI deemed ABN’s response as unsatisfactory and threatened action. TCI lacked the capacity to take over a bank of ABN’s size.They hoped other strategic bidders would join, and they did.

ABN’s suffered for years. It was an unfocused global conglomerate with little synergy among the countries in which it operated. Management was aware of the problem and making some incremental progress. They could not, however, make the difficult psychological choice to break up the bank. 

The consortium was a novel approach to handle the size and complexity of ABN’s business. RBS essentially took the international network (with the exception of Brazil and Italy which went to BST). The Benelux business went to FT. ABN tried to bring in Barclays as a white knight and sold their regional Bank, LaSalle, to B of A as a crown jewel defense to defeat the consortium. It failed and ABN was sold in October 2007 at a substantial premium to its pre TCI price.

One could argue that RBS and FT over paid and conducted inadequate due diligence. The market timing was also unfortunate as the transaction closed shortly before the great financial crisis of 2008 and both RBS and FT failed. Nonetheless, ABN’s sale released billions in trapped shareholder value. Additionally, the consortium did in the end what ABN managers should have done in the beginning-namely break up the bank. This illustrates the principle of doing onto yourself before others do unto you.

Joe