TARGET‐MANAGEMENT‐INVOLVED BUYOUTS: IMPACT ON TAKEOVER COMPETITION, LITIGATION RISK, AND SHAREHOLDER RETURNS

• Author: Sridhar Gogineni,John Puthenpurackal
• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/jfir.12039
• Date: 01 September 2014

TARGET‐MANAGEMENT‐INVOLVED BUYOUTS: IMPACT ON TAKEOVER

COMPETITION, LITIGATION RISK, AND SHAREHOLDER RETURNS

Sridhar Gogineni

University of Wyoming

John Puthenpurackal

University of Nevada–Las Vegas

Abstract

We examine the impact of target management involvement as bidders in a sample of

completed going‐private buyouts. Announcement‐period and long‐run target shareholder

returns do not appear to be lower in management‐involved deals. We attempt to identify

disciplining mechanisms in the takeover process that can explain this result. We find that

target shareholder lawsuits are more likely when management is involved, and litigation

risk appears to positively affect target returns. We also study a sample of withdrawn

buyout deals and find that a significant number of management bids are unsuccessful,

further suggesting that safeguards exist in management‐involved deals.

JEL Classification: G34

I. Introduction

Over the last several years, leveraged buyouts have become a significant part of the U.S.

corporate acquisition market. Eckbo and Thorburn (2011) document that the total value

of U.S. leveraged buyout transactions announced in 2006 and 2007 amounted to $450 and

$410 billion, respectively. A notable feature of these buyouts is that target management

are often part of the bidding group. This creates potential conflict of interests between

target management and shareholders that can adversely affect shareholder returns. The

extent to which this potential conflict affects target returns depends on whether safeguards

exist in the takeover process to manage this conflict.

Using a sample of 295 completed buyouts by financial buyers from 1995 to 2007,

we find that management involvement does not appear to reduce target buyout

announcement returns.

1

We then examine target returns for a subsample of deals

employing a negotiation selling method where the target board negotiates exclusively

with one bidder. Negotiation deals where target management is a part of the bidding

group, prima facie, suggest greater potential conflict of interests since the target board

negotiates exclusively with target management to set the buyout price. While the marginal

We would like to thank the JFR editors, Mehmet Akbulut, Audra Boone (the associate editor), Louis

Ederington, Veljko Fotak, Ben Gilbert, Scott Linn, Antonio Macias (the referee), Vikas Raman, Pablo Villar,

Alexandre Skiba, Pradeep Yadav, Andrew Zhang, and seminar or conference participants at the Financial

Management Association annual meetings and the University of Wyoming.

1

We define management‐involved deals as those where target management buys out the firm, either on its own

or as part of an investor group, by making an equity investment.

The Journal of Financial Research Vol. XXXVII, No. 3 Pages 323–356 Fall 2014

323

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

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effect of management involvement on target returns is less favorable in negotiation deals,

overall, we find that target management involvement in buyouts does not appear to lower

announcement‐period returns. This result is robust to controlling for the possibility that

management involvement is endogenous. To explain this finding, we examine potential

safeguards in the takeover process such as prepublic and public takeover competition,

shareholder lawsuits, institutional ownership, and board monitoring, which appear to

ensure fair target returns in management‐involved deals.

2

We find that prepublic takeover competition is significantly lower in

management‐involved deals. On average, 45% fewer potential bidders are contacted,

30% fewer potential bidders sign confidentiality/standstill agreements, and 26% fewer

potential bidders make private bids, when target management participates as a bidder.

This finding is consistent with nonmanagement bidders fearing the winner’s curse since

target management may be perceived as having an informational advantage (e.g., Bulow

and Klemperer 2002; Povel and Singh 2006). We also find that target shareholders obtain

higher returns in management‐involved deals when there is greater prepublic competition.

We next examine the threat of shareholder litigation as a potential disciplining

mechanism in management‐involved deals. A Wall Street Journal article titled “First, the

Merger; Then the Lawsuit”by Dionne Searcey and Ashby Jones, January 10, 2011,

discusses how an increasing number of lawsuits are filed soon after a takeover deal is

announced.

3

These lawsuits claim that shareholders are being shortchanged and acquirers

appear keen to settle them, often paying higher premiums to avoid delays in deal

completion. We contend that buyout transactions involving target management may be

particularly sensitive to litigation risk due to the potential conflict of interests and the

direct impact on shareholder returns.

After accounting for the possibility that the likelihood of shareholder lawsuits and

management involvement are endogenously determined, we document that management

involvement increases the likelihood of shareholder lawsuits. Furthermore, we find that

the threat of litigation has a positive impact on announcement‐period returns. This

indicates that litigation risk plays a significant role in eliciting higher target premiums.

We also study the effectiveness of other potential safeguards. Easterwood et al.

(1994) analyze 184 completed management buyouts from 1978 to 1988 and find that

public bidder competition is more effective than shareholder litigation and board

negotiations in obtaining higher target returns. Examining this issue over our sample

period is important because the landscape of leveraged buyouts has changed considerably

over the past three decades.

4

In our sample of completed buyouts, we find no statistically

2

Boone and Mulherin (2007) highlight the importance of prepublic competition. Prepublic takeover phase

refers to the period before the initial public announcement of a definitive merger agreement and involves activities

such as contacting potential bidders, signing confidentiality agreements, and negotiating private bids. The public

takeover phase kicks in once the initial public announcement is made and involves activities such as subsequent

price revisions and competing public bids.

3

A more recent article titled “Reasons to Be Suspicious of Buyouts Led by Management,”Steven M. Davidoff,

CNBC, February 6, 2013, addresses the potential conflict of interests when management is involved as a bidder.

4

For instance, consistent with earlier studies (e.g., Hartzel, Ofek, and Yermack 2004) that indicate mergers and

acquisitions have become friendlier, we find that the incidence of multiple‐bidder deals from 1995 to 2007 is about

43% lower than from 1980 to 1994. Source: Securities Data Company.

324 The Journal of Financial Research

significant relation between target returns and public bidder competition, board

effectiveness, or institutional ownership.

To get a more complete picture of returns to target shareholders, we examine the

period after the initial public announcement of the deal. We find that in the public takeover

phase, that is, during the time between the announcement date and completion date, there

is a higher frequency of upward revision of the initial public offer price and a higher

percentage change in offer price, for management‐involved deals. We study the reasons

for revisions of the initial public offer price and find the incidence of shareholder lawsuits

is a cited reason for 73% of the price revisions. Litigation risk thus appears to play an

important role in ensuring fair target returns in management‐involved buyouts. Our

detailed analysis of the relation between litigation risk and target returns adds to the sparse

evidence on this topic.

5

We construct several long‐run target return measures that capture the effects of

potential information leakage and earnings management before the deal announcement,

announcement‐period returns, price revisions, and resolution of deal completion

uncertainties. Using these long‐run return measures, we continue to find that target

shareholders do not appear to obtain lower returns in completed management‐involved

buyouts, on average. We conduct additional tests to confirm the validity of our findings.

We examine whether the timing of management involvement in the prepublic takeover

process, that is, whether the management‐involved bid is the initial prepublic bid, affects

its impact on target returns. We find a nonnegative impact of management involvement on

target returns when management makes the initial prepublic bid.

We also study a sample of withdrawn buyout deals to provide additional insight

into the above results. We find that a significant number of publicly announced

management‐involved deals are subsequently withdrawn, with competing offers, target

board opposition, and shareholder lawsuits being the most common reasons. This

indicates that the mere fact that management is involved in an announced deal does not

ensure its completion. The takeover process appears effective enough to ensure that only

more value‐creating deals for target shareholders are completed, on average. This

provides further support to our earlier results and indicates that effective safeguards for

target shareholders exist in management‐involved deals.

II. Hypothesis Development

Other researchers have studied the potential conflict of interests in management‐involved

deals with mixed conclusions. In a study of buyouts involving management, DeAngelo,

DeAngelo, and Rice (1984) conclude that target shareholders obtain significant positive

returns. Also supporting a benign view of target management motives, S. Lee (1992) finds

5

We are aware of two studies that explore the relation between target shareholder returns and litigation risk.

Bates, Lemmon, and Linck (2006) examine how litigation affects the likelihood of bid revisions in freeze‐out deals.

We provide a more detailed analysis of how litigation risk affects target returns in management‐involved deals.

Krishnan, Masulis, and Thompson (2011) examine litigation in mergers and acquisition but their emphasis is not on

management‐involved deals.

Target‐Management‐Involved Buyouts 325