What To Do After A Takeover

Foreword from ShareInvestor

This article “What To Do After A Takeover” by Teh Hooi Ling was first published in The Business Times on 15 Apr 2006 and is reproduced in this blog in its entirety.

If the buyer paid cash for your shares, use the cash to buy its shares; if it’s by shares, convert them to cash

LET’S say you have a portfolio of stocks. Be it luck or skill, you happen to be holding two companies that have become takeover targets.

In the case of the first company, let’s call it Target A, the purchaser is financing the acquisition with cash. So as a shareholder of Target A, you will receive cash for your shares. In the case of the second company, Target B, the buyer is issuing shares to pay for the acquisition. So your 1,000 shares in Target B may be exchanged for, say, 200 shares in Buyer B.

What should you do in this situation? Keep the cash from sale of Target A and the shares in Buyer B and hold on to them?

Well, apparently the best thing you can do for yourself, the course of action that will most likely yield the best return, is this:

  • Use the cash you receive from sale of Target A to buy shares of the acquiring company, Buyer A; and
  • Sell your shares in Buyer B immediately and convert them to cash.

Empirical Evidence

Here’s the reason. Studies have found that companies that use stock to acquire targets tend to turn in miserable five-year returns, whereas companies that use cash greatly outperform matching companies of comparable size and book-to-market ratio.

In a paper published in 1997, Loughran and Vijh studied 947 acquisitions from 1970 to 1989.

They found that companies that used their stock as currency under-performed a group of stocks with matching characteristics by 24.2 percentage points five years after the acquisition.

In contrast, firms that did all-cash deals outperformed by 18.5 percentage points five years down the road. And acquirers that used a mixture of cash and stock earned an excess return of 7.4 percentage points over the same period.

The researchers also found significant difference if a takeover was friendly or hostile. Acquirers that used cash as part of a hostile tender outpaced those who used cash in a friendly merger by a whopping 47.9 percentage points.

From the point of view of a shareholder of a target firm, gains have already been made once the proposed deal is announced, as the purchase price is usually at a premium to the market price. At this point, Loughran and Vijh found that there was no difference in the abnormal return in the target share price whether the offer was all-cash (26.1 per cent) or a stock acquisition (25.1 per cent).

However, the cumulative return from the period before the announcement of the merger or tender offer to the point five years after the effective date of the acquisition could differ substantially.

Targets of stock mergers showed long-term returns 14.9 per cent in excess of matching stocks. But shareholders of companies acquired in cash tender offers saw long-term returns 138.3 per cent above those turned in by matching stocks – that is, if they used the cash to buy the acquirer’s stock.

The authors thus arrived at this advice for investors. ‘The target shareholders who receive acquirer stock in exchange for their holding should sell out for cash when they receive that stock. Shareholders who receive cash in exchange for their holding should go to the market and buy the acquirer’s stock.’

So what would explain the under-performance of a stock offer vis-a-vis an all-cash offer?

As Loughran explained in an interview: ‘Imagine that your stock is trading at $50. You’re the manager and you know it’s worth $100. Would you issue stock? No way. But what happens if you knew it was really worth $10. It’s the first thing you’d be doing. You’d be going out and buying companies.’

Just as a seasoned equity offering should alert investors to the likelihood that a stock is overvalued, so too should an acquisition involving a stock swap.

On the other hand, companies that use cash to make acquisitions are signaling that their stock is undervalued.

Furthermore, stock acquirers tend to be growth firms. Hence, it is possible that both managers and the market were overly optimistic about the firm’s growth potential and the managers’ ability to generate growth from the acquired outfit.

Meanwhile, hostile takeovers tended to yield better long-term returns because they were usually followed by changes in the target company’s top management and, often, improvements in operations.

A hostile, all-cash tender offer thus signals two distinctly optimistic opinions.

First, the acquirer believes its stock is undervalued. Second, this company is so certain it can improve the target firm’s results that it is willing to use cash to make the deal happen.

Loughran and Vijh also found that the larger a target company was relative to the acquirer, the worse the long-term stock performance. In fact, companies that acquired firms that were two-thirds their size or bigger saw their stock under perform the stock of matching firms by 47.4 percentage points.

Loughran explained that when a company’s stock is really overvalued, it is most likely to use that stock to acquire a very large firm. The relative size of the target, then, may signal the degree to which insiders consider their company’s stock overvalued.

If we study some of the major acquisitions in the Singapore market in the past few years, anecdotal evidence seems to confirm the findings of Loughran and Vijh.

For example, in November 2001, Fraser & Neave launched an all-cash deal to take Centrepoint Properties and Times Publishing private. Minority shareholders were offered $2.07 cash for every Centrepoint share and $4.48 for each TimesPub share.

These figures represented premiums of 23.2 per cent and 24.4 per cent to the last transacted prices of Centrepoint and TimesPub.

If shareholders of Centrepoint and TimesPub had used the cash to buy F&N shares, they would have hit the jackpot. Between Dec 31, 2001 and March 31, 2006, F&N rewarded its shareholders with a total return of 295.6 per cent. That’s a whopping 240 percentage points ahead of the return of the Straits Times Index.

Also in 2001, Keppel Corp proposed to take three of its subsidiaries private with an all-cash offer. Two of them – Keppel Fels Energy and Infrastructure and Keppel Hitachi Zosen – were successfully privatised.

But the minority shareholders of Keppel Telecommunications and Transportation (KTT) rejected the offer.

Bigger Jackpot

Had these shareholders taken the money and invested in Keppel Corp shares, they would have hit an even bigger jackpot. Between early 2002 and March 31, 2006, Keppel Corp shares’ total return was a stunning 497.22 per cent.

Perhaps in hindsight, KTT shareholders should have accepted Keppel Corp’s offer and ploughed the money back into the parent. In the last five years or so, KTT managed a return of 94 per cent – albeit respectable, but significantly lower than that of Keppel.

Among the banks, OCBC financed its purchase of Keppel TatLee entirely with cash, while UOB bought OUB and DBS bought Hong Kong’s Dao Heng in cash and stocks.

Of the three banks, OCBC has created the most value for shareholders in the past five years or so. A survey by consultants Mercer Oliver Wyman ranked OCBC second among Asian banks that delivered the highest returns for shareholders over the past five years.

OCBC has outranked UOB and DBS for two years in a row now. In the most recent survey, only Hong Kong-based Bank of China beat OCBC.

Another big acquisition done by a Singapore company in 2001 was Singapore Telecommunications’ takeover of Australia’s Optus.

The deal was paid for with stock-cum-cash. Optus shareholders who opted for SingTel shares and are still holding on to them today would have suffered significant underperformance.

Between Aug 31, 2001 and March 31, 2006, SingTel shares under-performed the STI by 30 percentage points. So it seems that Cable & Wireless – the majority shareholder of Optus – understood the principle of cash-good-stock-bad in a takeover situation.

Soon after the agreement was struck, Cable & Wireless inked a deal with an institutional investor to sell most, if not all, of the SingTel shares it would receive as payment for its 52.5 per cent stake in Optus.


So what can you take away from all the above evidence? Well, it has been shown time and again that companies do take advantage of the market’s inefficiency by attempting to raise capital when they think their share price is overvalued.

In such situations, capital is available to the companies at very low cost. There is no fixed financial obligation to shareholders. And inexpensive capital encourages managers to undertake actions that are detrimental to stockholders, both existing ones and those who buy into an offering or gain a stake in a company by way of a stock swap.

Indeed, the fact that all-cash tender offers wildly outperform stock mergers and other studies suggest that higher capital costs actually lead managers to act more responsibly in pursuing growth opportunities. So the next time a company issues new shares to buy something, look long and hard at its management and its financials. It may be a signal to jump ship.