white and black knights: the dynamics of M&A

black knight, white knight

In retellings of the Arthur legends, many times the heroes wore light-colored armor and the villains black.  Sometimes, though, the black knight was a good guy in disguise or just someone who didn’t have a steady job at the moment.

The “white hat = hero, black hat = villain” convention was much more rigorously applied in the cowboy movies that dominated film and TV a generation or more ago.

The visual cues continue today.  But since people don’t wear hats as often as they used to, and because product placement has become more important as a revenue source, the metaphor has changed.  In the TV adventure show 24, for instance, the heroes use Apple laptops, the bad guys use generic PCs (with logos that could be either Dell or HP).

still used in mergers an acquisitions

In mergers and acquisitions, the terminology remains the tried and true.  A black knight is a company that makes an unsolicited, unfriendly (i.e., against the wishes of the target) bid for another company.  A white knight defends the target by making a higher bid, with the approval–and often the encouragement–of the target’s management.  Why does this make any difference?1.  Individual shareholders almost always vote with management, in my experience, no matter what the proposal is or where the individuals’ true economic interests lie.  I don’t know why this is the case.  But I’ve seen it happen for thirty years.  It doesn’t matter how badly the current regime may have mismanaged the firm or how absurdly high the offer on the table may be, individuals will vote the way management recommends.

Institutional investors are just the opposite.  If anything, they are a little more prone to grab the takeover money and run, even if the offer is on the low side.

All other things being equal, though, it tends to be an uphill climb for a potential acquirer that doesn’t have management on its side.  The bidder needs overwhelming support from institutions.

2.  Managements become addicted to being in charge, so they’re very unwilling to step down, especially for a hostile acquirer who has not promised cushy new jobs for them.

CEOs get to be in charge.  They have big offices, unrestricted use of the corporate jet (who’s going to tell them “no”?) and a special dining room.  They receive daily adulation from fawning subordinates.  What’s not to like?

If their company is taken over, at best they’re now a division chief.  They’re a fawner, not just a fawnee.  No more calls from the White House, no more Davos, no more jetting all over the place.

At worst, they’re out on the street–rich, yes, but still in the eyes of the outside world just broken-down old retired people who can’t walk fast enough to get out of younger people’s way.

3.  Once a bid is tabled, the company is in play and will likely be acquired. That’s pretty well understood by all parties.  The incumbent management can only influence who the ultimate acquirer is, and what price he pays.  Since the initial bidder is the source of all the horrible stuff in #2, current management will normally do everything in its power (remember, its recommendation will probably deliver the votes of the 20%-30% of the shares held by individuals) to make sure the black knight doesn’t win.

4.  No one wants to make the first move. Firms may spend years studying their rivals for their potential fit as acquisitions.  We’re now in the prime time for “strategic” or “trade” buyers (as opposed to private equity, so-called “financial” buyers).  Why?  Recession is over.  The business cycle is turning up.  Valuations remain reasonable.  Stock market investors don’t yet have enough confidence in the earnings potential  over the next few years to demand premium prices for fhe stocks they hold–which they will likely start to do as recovery unfolds further.

Yet, no one wants to make a hostile move.  Everyone wants someone else to put the black hat on, which will leave the white knight role open for them.

5.  On the other hand, no one wants a bidding war. Over 50% of mergers don’t achieve the anticipated results.  Once in a while, there’s a corporate culture clash.  Occasionally, the bidder opens the big shiny present he’s paid a fortune (in stock or cash) for and finds there’s nothing inside–as Time Warner did when it bought AOL.  Most of the time, though, the acquirer pays too much.

Anyone who’s been to an auction knows why.  People get carried away when they’re bidding.  This is even more true if the target is important, you’ve spent the past year planning the integration, and you start to see the prize slipping through your fingers–to someone you don’t like and who’s offering “only” 5% more than you. Before you know it, you’re bidding 20% more than you intended.

6.  A smart black knight makes a “knockout” bid, that is, offers a full price from the beginning, one that competitors will hesitate to top.  The strategy may not always work, but it’s the best counter, I think, the black knight has to the animosity it creates in the target’s management.

7. A merger-driven market is great for value investors. For growth investors?–not so much.  Fast-growing companies with relatively high p/e ratios are most often acquirers.  Asset-rich firms with strategic industry positioning but low earnings multiples and mediocre management are most often targets.

This isn’t always true–think:  DIS buying Marvel Entertainment or KFT acquiring Cadbury–but it’s a good general rule.

If the potential acquirer wants to get anyone to tender shares, he has to offer a substantial premium to the prevailing market price.  So the target’s stock goes up on news of the bid.

The acquirer’s stock almost always goes down, as investors worry about the potential dilution the acquisition will cause.  In the case of a bid for stock, risk arbitrage will depress the bidder’s shares automatically.

So while value-oriented portfolio managers must be rubbing their hands in anticipation of this year’s developments, growth stock managers are resigning themselves to finding leaks in the sides of their portfolio boats.

Should you buy companies because you feel they’re acquisition targets?

In general, I don’t think so.  Good for you if you find a company you like, buy it and you’re rewarded faster than you expected by having it taken over.  Buying stock in a company you don’t like, on the idea it will be bid for, exposes you to the risk that no takeover emerges and your stock stagnates–or worse.  Still, if you think of takeover as the icing on the cake and you’re choosing between two roughly equal companies, taking the one with the icing on it makes a lot of sense to me.

Risk arbitrage, or investing in companies after an initial bid, is a highly specialized undertaking.  But it’s much more like the conventional finance taught in school than what portfolio managers do.  So a professionally trained finance person isn’t really at a conceptual disadvantage.  Two drawbacks, other than lack of practical experience with the turn of mind arbitrageurs use, for you and me, though.

Professional risk arbitrageurs have a significant cost of capital advantage over the rest of us and are perfectly willing to use leverage.  Also, it’s almost impossible to conceive how much more fundamental information on companies is available to professional investors than to the rest of us, or how quickly it circulates in the market.  So, while it’s possible to make money, it probably won’t be on the scale that professional arbitrageurs do.

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