Shark Repellant Common Among Recent IPOs

IPO Reporter
Colleen Marie O'Connor
01/28/2002
Copyright (c) 2002 Thomson Financial, Inc.

The tide is turning for the once unfashionable inclusion of takeover defenses at the point of a company's IPO. According to those studying the phenomenon, in recent years, it has become increasingly more difficult for a company to host an IPO without first sharpening its metaphorical spears in anticipation of a takeover.

Traditionally, takeover defenses - also affectionately called shark repellant - have been viewed with disdain when incorporated at the time of a company's public offering. These defense methods, designed to thwart unwanted and unsolicited outside takeover bids, were known to decrease the value of company stock at that crucial time when underwriters need every aspect of the deal to look as good as possible on paper. Furthermore, many thought that while designed as shark repellent, these defenses were actually providing methods for management to comfortably entrench themselves within their company. However, a new study shows this isn't the case anymore. "It's generally thought that takeover defenses are destructive, that they entrench managers, that they don't work in the shareholders' best interest," said Laura Casares Field, assistant professor of finance at the Smeal College of Business at Pennsylvania State University. "After all, one of the ways to discipline managers is for shareholders to vote them out if they didn't run the firm well," she said.

As co-author of a study called "Takeover Defenses of IPO Firms," Field, along with Jonathan Karpoff of the University of Washington and Emory University, spent five years on the study, which sampled 1,019 IPOs from 1988 through 1992. It is due to be published in the October issue of the Journal of Finance.

Somewhat surprisingly, the study found that a sizeable portion of companies - 53% of those studied - did include at least one takeover defense at the time of their IPO. "These findings are surprising because managers of IPOs should have incentives to maximize the value of the firm. If takeover defenses decrease firm value, which is the conventional wisdom, then it is perplexing that IPO managers would implement them," explained Field.

But the bottom line is, while takeover defense might decrease stock value, they do serve their main purpose.

"We found firms that have takeover defenses are less likely to be acquired," said Field, "and they don't appear to entrench managers."

The research revealed the three most common shark repellent methods employed: 85.1% of those studied used blank check preferred stock, which can be issued to parties friendly to management to block hostile bids; 30.4% preferred shareholder meeting restrictions, which prohibit shareholders other than directors or executives from calling a shareholder meeting; and 28.9% used supermajority vote requirements, which push approval levels from a majority to, for example, 75% or 85% of outstanding voting rights.

The study also dispelled a theory that takeover defenses lead to a better bargaining position during an acquisition. "We were not able to find they were able to abstract a larger price. It appears unlikely that takeover defenses help in the eventual sale of the firm by increasing expected takeover premiums," she said.

The real surprise for Field regarded the theory of a diminished operating performance because of manager entrenchment. "We looked to see if the manager was running the company into the ground," she said, citing opportunities such as less oversight by the board, or if a company CEO was also the chairman of the board. "We didn't see that in terms of operating performance," said Field.

Blame The Lawyers

Harvard University Professor of Law John Coates also concluded that half of newly public companies adopt substantial defenses prior to IPOs, contrary to popular belief. Additionally, Coates found that attorney selection played a large role in takeover defenses. His paper "Explaining Variation in Takeover Defenses: Blame the Lawyers," published in 2001 in the California Law Review, studied a sampling of public offerings from 1990 to 1992 and those between 1998 and 1999.

"I wanted to see if there was any explanation for why some companies had defenses and others didn't," said Coates. "By far the most important predictor was the lawyers... in particular, how much takeover expertise did the law firm have? If they had lots of M&A experience, then lots of their clients tended to have lots of takeover defenses, and if they had very little experience, their clients did not [have many defenses]," he said.

In an interesting twist, Coates found that many Silicon Valley-based lawyers in the early 90s never included takeover defenses. This pattern appeared among some other Palo Alto firms, but was not true for law firms in the rest of California. However, by the late 90s, that pattern was diffused as most law firms, regardless of location, began and continue to include takeover defenses. Coates chalks this up to takeovers becoming a higher profile risk in the late 90s for those working in the tech-heavy arena. He also noted the education of clients, which in addition to factors like location and access to capital, began choosing attorneys based on their level of M&A experience.

"Takeover defenses have become a growing area of interest, largely as more people become aware of them," said Tom Quinn, COO of TrueCourse Inc., a company that tracks and uses a weighted index, called the Bullet Proof Rating, to rank takeover defenses of IPOs via its sharkrepellent.net Web site.

Protection for IPOs increased between 2000 and 2001 said Quinn. The average Bullet Proof Rating for 2001 IPOs was up .12 percentage points, to 4.75 from 4.63 in 2000. Why the slight rise in just one year?

"Companies going public in the third or forth quarter one year ago are now seeing their stock prices hammered. People going public face a different environment today, where the question arises, am I a target?' This heightened risk factor is reflected in last year's public offerings," said Quinn.

Similar to Field's research findings, Quinn found that blank check preferred stock was the overwhelming favorite takeover defense, found in 96% of IPOs in both 2001 and 2000. The use of classified boards, however, dipped to 70% in 2001 IPOs from 73% in 2000. Poison pills, securities that entitle holders to special rights triggered only during an unsolicited takeover bid, jumped to 27% in 2001 from just 21% in 2000. But the takeover defense seeing the most action over the last year has been the expanded constituency provision, which enables a company's board to consider the interests of groups other than shareholders (i.e. employees) during a bid. This specific provision jumped to 11.43% for 2001, compared to 5.24% in 2000.

KPMG Consulting Inc. (NNM: KCIN) received a perfect 10 when ranked by TrueCourse. "It's actually very rare to be so totally loaded," said Quinn. "But overall, takeover defense options are increasing in light of general awareness."

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REPORTERS & EDITORS: For more information, please contact Wyatt DuBois in the Smeal College of Business Media Relations Office at 814-863-3798 or wed112@psu.edu .

Penn State's Smeal College of Business offers highly ranked undergraduate, MBA, executive MBA, Ph.D., and executive education opportunities to more than 5,500 students at all levels. Featuring academic departments of accounting, finance, marketing, insurance and real estate, management, and supply chain and information systems, the college is also home to major research centers such as the Center for Supply Chain Research, the Institute for the Study of Business Markets, the eBusiness Research Center, the Farrell Center for Corporate Innovation and Entrepreneurship, the Center for Global Business Studies, and the Center for the Management of Technological and Organizational Change.

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