The views expressed in this post, as in all of my posts, are mine alone and should not be taken to represent the views of Fasken Martineau DuMoulin LLP or any of my partners or associates.
A little over five years have passed since the U.K. Takeover Code was reformed on September 19, 2011 in order to prohibit deal protection provisions — including lock-ups, “no shop/no talk” covenants and termination or “break” fees — in M&A deals involving the acquisition of publicly-listed U.K. companies. Seizing upon a rare and valuable opportunity to conduct some natural experiments into the effect on the U.K. M&A market of this regulatory change, a pair of students from Stanford and Harvard recently published a study on the impact of the 2011 Reforms on U.K. deal volumes, the incidence of competing offers, deal premiums and deal completion rates.[i] The results of their study are both interesting and instructive.
Among other things, they found that:
- the ratio of U.K. deals to non-U.K. deals[ii] decreased by approximately 50% after the 2011 Reforms;
- this reduction in deal volume was not offset by any increase in the incidence of competing offers or deal premiums in the U.K.; and
- as a result, the U.K. M&A market experienced an estimated quarterly loss of approximately US$19.3 billion in deal volume following the 2011 Reforms, implying a quarterly loss, assuming a conservative average deal premium of 20%, of approximately $3.3 billion to shareholders of U.K. public companies since the 2011 Reforms were put in place.
Based upon these findings, the authors of the study suggest that the “…benefits of deal protection are real: that is, potential bidders are deterred from initiating M&A deals when they cannot recoup their out-of-pocket expenses and other costs in a failed M&A deal.” Accordingly, “deal protections provide an important social welfare benefit by facilitating the initiation of M&A deals.” Conversely, by prohibiting deal protection provisions, the 2011 Reforms implicitly favoured competition following announcement of the deal and the resulting potential for increased deal premiums (neither of which ultimately materialized, according to the study) over deal initiation. But in light of the elasticity of deal initiation to the costs of such initiation, as well as the significant social cost in lost deal volume resulting from fewer initiated transactions, the authors conclude that deal initiation costs “should be acknowledged and accommodated by policymakers.”
It may seem obvious that regulators should be sensitive to deal initiation costs in making policy. As a matter of general economic principle, leaving aside so-called “Giffen goods” (items like perfume, jewelry, high fashion or other luxury goods, demand for which tends to move in tandem with movements in price) one can expect demand for an item to decrease as the cost of the item increases. That principle generally holds true, whether we’re talking about local produce or M&A deals.
But, for whatever reason, regulators appear to regularly lose sight of that principle. A further example is provided by the changes made to the takeover bid rules in Canada earlier this year. By extending the minimum bid period to 105 days (with certain exceptions) from the prior minimum of 35 days, Canadian securities regulators were explicitly addressing concern that “offeree boards [did] not have enough time [under the old bid regime] to respond to unsolicited takeover bids with appropriate action, such as seeking value-maximizing alternatives…” In other words, the new minimum bid period was designed to promote more competition (and correspondingly greater deal premiums) in the context of hostile bids.
The problem of course is that, like the 2011 Reforms in the U.K., the costs of deal initiation appear to have been overlooked by Canadian regulators in promulgating the new bid rules. To begin with, for bids that require financing, lenders could demand a significant increase in commitment fees now that funding to complete a hostile acquisition must remain available for up to three times as long. Beyond that, there are other, non-pecuniary costs, including reputational capital, at stake for bidders that are exposed to interloper risk for an extended period. Empirical studies demonstrate, among other things, that CEO turnover rates are higher in the case of companies involved in failed acquisitions. This is likely to have a greater deterrence effect on deal initiation where third parties have a bigger window of opportunity to come in over the top of any deal, increasing the probability of its failure. And that’s before even mentioning the significant additional investment in managerial resources required to maintain a bid in place for so long.
As with the 2011 Reforms, there is good reason to question whether these added costs of deal initiation will be justified by a corresponding increase in competing offers. Fasken Martineau’s 2015 Canadian Hostile Bid Study indicated that, in over 90% of cases in which competition for a hostile bid has historically emerged, it has emerged before the bid was 75 days old.
If history serves as a useful guide, the new 105-day minimum bid period therefore leaves a period of 31 days — almost as long as the old minimum bid period — during which bidders will be exposed to material incremental costs of deal initiation while target shareholders receive no corresponding benefit in the form of a material prospect of a competing offer.
The risk this creates is not simply that initiation of hostile bids is being unnecessarily deterred, which promises to result in fewer of them. That might well be a risk that regulators are prepared to take: the Canadian market has averaged a mere nine hostile bids over the past five years so it’s not as though there’s a torrent of hostile bid deal-flow at stake.
The real risk is that, by deterring the initiation of hostile bids, the new bid rules significantly alter the dynamics of “friendly” deal negotiation. Bidders stand to lose bargaining leverage to the extent that the marginal costs of hostile deal initiation erode the credibility of their implicit threat of by-passing the target board and taking their offer directly to target shareholders. Without the disciplining effect of that threat, it may turn out that some target boards are less open to negotiating friendly deals in good faith. And if things do in fact turn out that way, the new bid rules, like the 2011 Reforms to the U.K. Takeover Code, could result in billions of dollars of lost annual deal volume and shareholder value.
That’s a risk that Canadian securities regulators can’t reasonably afford to take lightly, and one that they’d therefore do well to monitor as time passes and the impact of the new bid rules becomes clearer.
[i] F. Restrepo and G. Subramanian, The Effect of Prohibiting Deal Protection in M&A: Evidence from the United Kingdom
[ii] The authors compared deal volumes in the U.K. to control groups consisting of (i) other European G-10 countries and (ii) the U.S., with statistically similar results.