21 June, 2016
I INTRODUCTION
In the global business and finance arena, it is widely believed that the primary goal of a corporation is profit maximisation. No rational entrepreneur, even a charity organisation, is willing to maintain a loss making business save for specific purposes, say taxation. It is, therefore, deemed that corporate exercises, including mergers and acquisitions, the motives behind which are always value adding. Put it in financial terms, net present value for particular transaction should be larger than zero (NPV > 0) to proceed with.
In reality, most of the commercial transactions are initiated and signed off by management on the company’s behalf, instead of shareholder per se. The management, who runs the company, if not for hostile purpose, may not always share identical aim with the shareholder of a body corporate. According to agency theory, agency cost is incurred stemming from different interests and information asymmetry between shareholders (as principal) and manager (as agent). As such, it is submitted that merely Value Maximisation theory cannot explain all the commercial decisions, including reverse takeover.
Over the past years, a considerable number of empirical studies have been conducted to explain mergers and takeovers activities, including reverse takeover, with financial theories such as Value Maximisation, Social Efficiency and Empire Building, the results of which are yet inconclusive.
Compared with the voluminous researches on of merger and acquisition, reverse takeover, being a specific type of acquisition transaction, is seldom discussed and examined by Value Maximisation theory and Empire Building theory, let alone Opportunism. The author tries to examine whether Opportunism in fact plays a crucial role in determining backdoor listing by way of reverse takeover, for which the decision is generally made by the management, whose motivation is not solely driven by value adding.
There are basically two kinds of motivation for an acquisition, namely Value Maximisation and Non-value Maximisation, which are regarded as wealth enhancement based and powered based respectively.
II VALUE MAXIMISATION
Regarding Value Maximisation, there are three divisions to explain takeover and related transactions, which are Efficiency, Market Inefficiency and Wealth Expropriation theories. To apply theory of Value Maximisation on reverse takeover, one might find out the financial return or gain that the acquirer obtained subsequent to the acquisition. Stock price data can also be referred to if bidder and/or target is/are listed on any stock exchange. For instance, in 2013, Greenland Holding Group Company, a Chinese state-owned developer, acquired the majority shares of a company listed in Hong Kong resulted a soar of share price for over 100 per cent.
However, it was submitted the results are plausible because not every acquisition results in a normal return. For instance, if the target is much smaller in scale than the acquirer, it shall be unlikely for the acquisition to generate a significant return for the acquirer. It was argued that greater return for acquirer if the target is larger.
On the other hand, the measure of the stock price acquirer may not always reflect the truth due to the fact that stock price always reveal market expectation and information which is unrelated to particular acquisition. Besides, for those listed acquirers who have active transactions of merger and takeover, the stock price might have reflected the gain once the relevant announcement is made. These show that stock price data might not be reliable to measure the actual gain for the acquirer to test the theory of Value Maximisation.
In addition, the acquirer and target form a new group of company and their accounts shall be consolidated post the acquisition. Sometime, even the acquirer records a negative return, its loss has to be aggregated with the target’s return to result in a positive return. It was, therefore, contended that those takeovers which are apparently non-value maximising, are indeed beneficial to the group companies and the society at large. However, the empirical results are mixed.
A Efficiency
Notwithstanding the diverse views, Value Maximisation is the major theory to explain takeover transactions. From the efficiency aspect, reverse takeover can generate synergy gains and reduce agency cost. It is undeniably that reverse takeover should achieve a result that the value of merged group of companies is larger than each of the single company separately stemming from operation efficiency or economic synergies.
Synergy is produced whenever a firm that is short of efficient management resources being acquired by a firm which has excess managerial capacity. This synergy explanation is well supported by findings evidencing the positive correlation, if not causation, between returns of acquirer and target as well as corporate with combination of managerial resources and skills.
Although Goodwill can be generated following the acquisition, it is considered spurious to the market because this financial synergy can be manipulated by different accounting methods. Some studies even demonstrated that financial synergy is not the major motivation for takeover. According to some studies, financial return of nearly half of a sample of international acquisition did not meet the cost of capital of the acquirer.
Reduction of agency cost is another head of efficiency explaining takeover, which is clever but not convincing as an explanation. In a takeover, even not for a hostile one, inefficient management is usually replaced since takeover bypass the target’s management and reach the shareholders of the target company directly. Instead of an explanation, reduction of agency cost should be considered as the consequence and impact for a takeover, including reverse takeover, because the acquirer would not proceed with takeover merely for reduction of agency cost of the target without other financial gain or return to itself. On the contrary, inefficiency of management and even market may explain the motivation of reverse takeover.
B Market Inefficiency
Market Inefficient theory under Value Maximisation is based on the premise that stock price of listed company does not represent its true value. Acquirer shall endeavour to identify listed company which is undervalued and then acquire the same under the correct valuation so as to make the profit out of the difference between correct value and the bidding price.
However, this theory is not without its drawback. If this explanation is actually valid, the price for the target company shall remain as high as predicted by the acquirer once it is identified no matter there is an actual acquisition.
On the other hand, it was suggested that investor is willing to sacrifice benefit in the long run for short term profit, which is called myopia inefficiency. Usually, company with long term investment plan would put much fund in research and development, which should result in under valuation by the market and thus being targeted by acquirer. Manager of those companies shall turn to short term project to prevent from under valuation. However, this myopia explanation does not have much support empirically.
C Expropriation
Another head of Value Maximisation is expropriation, which is also known as wealth transfer. Tax benefit is considered as one obvious explanation for takeover transaction. It is based on the premise that a company cannot utilise its tax deduction items, depreciation allowance or net operating loss because it has, if not none, too little income. Such company probably intends to seek an acquirer to acquire its company so as to capture the tax benefits, which means the acquirer can protect its income from paying tax and at the same time the company can realise the tax deduction.
However, there are not many studies supporting the tax perspective as an explanation of takeover. Amongst the takeover transaction, there is only a small proportion of cases can be categorised that the transaction enjoy obvious tax benefit. Besides, the impact is not material compared to other financial gains or benefits.
Market power is considered as another category falling under the expropriation theory explaining takeover. Through acquisition, company can obtain a monopoly power enabling it to increase its product price over marginal cost and to extract surplus earning from the customer. However, its importance plunges following the legislations which prohibit competition and monopoly, for instance antitrust laws in the United States (“US”) and expectedly the same situation would take place in Hong Kong due to the enforcement of Competition Ordinance.
III EMPIRE BUILDING
Every corporate decision is made by management on company’s behalf and the mentality of management must be taken into account to explain reverse takeover. No matter how accurate to explain the motivation of reverse takeover from the financial and market perspective as discussed in previous sections, it is evident that the managers are not always adhere to the realm of merely enhancing the wealth of shareholders through takeover or reverse takeover. In fact, research shows that the consideration of a large number of acquisitions is more expensive than the value. Also, over half of the acquisitions of US companies ended up unsuccessful.
It comes to empire building theory here, which is regarded as a Non-value Maximisation explanation. “Self-aggrandizement” is a term to describe the situation that the managers maximise their utility instead of increasing the shareholder’s wealth. In empire building, individuals in the corporation use its power to initiate projects to achieve own job security or self interest. Studies show that there is positive correlation between acquirers return and the stock owned by managers. This findings show that the intent of manager indeed playing a vital role in determining which corporate exercise to take and thereby affecting the shareholder’s wealth.
Some other researches show that there is a positive relation between return to acquirer and independence of its board of directors. Results demonstrated that the return to acquirer shall diminish with the increase of outsider director sitting in the board of acquirer. This suggested that directors without scrutiny shall be prone to proceed with non-value maximisation acquisition.
Moreover, under the hubris hypothesis, management makes mistake by, say, overvalue the target, when they intend to proceed with a value maximising acquisitions. Managers with pride would persist their view and end up paying extra cost for the target company, as a result of which the wealth from the acquirer’s shareholder is transferred to the shareholder of the target company. This action amounts to an empire building by the management which can, to a certain extent, explain the motivation of takeover, include reverse takeover.
Although sometimes the management makes wrong decision, it was founded that net return to the whole acquisition is positive. Studies shows that the gains by target is higher than loss suffered by the acquirer, which implies that there is more than wealth transfer from acquirer shareholder to the target company’s shareholder. In this circumstance, wealth transfer for the acquisition is in effect accompanied by third party.
IV IMPLICATIONS
A Opportunism
Being a specific kind of takeover, it is undeniably that reverse takeover is a mean to maximise the value of a company. However, merely the theories of Value Maximisation and Empire Building are not sufficient to explain reverse takeover flawlessly. Some may posit that reverse takeover can be explained by Efficient Market hypothesis. However, such hypothesis cannot predict the opportunity available to or undertaken by any corporation.
In Hong Kong, many cases of reverse takeover involved Chinese property developers and real estate companies. The deal value for Hong Kong listed companies being purchased amounted to over HK$9 million by at least seven such Chinese companies from April 2012 to May 2013. Research showed that those Chinese companies faced the same question, which is the barrier to raise fund such as initial public offering (“IPO”) in the mainland China or Hong Kong.
In addition, reverse takeover enabled a distressed listed company to have an opportunity to utilise its listing status to realise its intrinsic value. This opportunity of backdoor listing may also be the last resort to rescue the distressed listed company by which the creditor can recover some, if not the entire, of their bad debts. Restructuring by way of backdoor listing is, therefore, regarded as an opportunity for an alternative of liquidation.
Save for Value Maximisation and Empire Building, reverse takeover also allows the Chinese companies to purchase offshore listed shell, which increase the opportunity to access equity financing in overseas capital market and thus diversify the channel for fund raising. For example, a listed company has the option to issue and allot additional share under a secondary offering or even use share option scheme to retain valuable staff in a company. In this connection, reverse takeover is rather a tactic, which is also regarded as an opportunistic behaviour, for the acquirer to attain its listing status.
On the other hand, it was suggested that more difficult market for IPO would result in an increasing number of backdoor listing by reverse takeover transaction. This suggests that the reason companies choose for backdoor listing instead of conventional IPO is, to large extent, based on opportunity and circumstance of the market.
Back to the definition, Opportunism is a practice of taking advantage of circumstances mainly driven by self interest, no matter a person or a corporation, but with little consideration of general principles. Although there is no general definition for Economic and Legal Opportunism, they usually refer to the gaining of interest and status by legitimate legal arrangements to get around some other rules, like morality.
Reverse takeover is generally prohibited by stock exchange in many jurisdictions. Acquirer shall use some legal arrangements such as purchase of listed company with same kind of business so that it would not trigger the two years period rule under the bright line test and anti-avoidance provisions.
In order to avoid breaching the more and more intense regulations, it was also shown that the cost for reverse takeover has risen the past years. This is regarded as the opportunity cost for the acquirer.
B Regulatory Response
In view of the growing number of reverse takeover as a way for backdoor listing, stock exchange in different countries respectively amend their reverse takeover rules and regulations in order to scrutinise acquisitions to protect investor and shareholders, especially those in minority. For instance, The Stock Exchange of Hong Kong Limited (the “Exchange”) has issue the Guidance Letter in May 2014 to address the issue that many acquirers successfully done the deals without being categorised as reverse takeover, with the aim to decrease the opportunity for illicit use of reverse takeover. After the reverse takeover rules were tightened by the Guidance Letter, the Listing Committee reported a notable drop of number of reverse takeover transactions, which was from eleven cases in 2014 to one case in 2015.
One of the major guidance by the Guidance Letter is that transaction shall be considered an “extreme” case depending on the relative size of the transaction, quality of business being acquired, nature and scale of listed shell’s business, issue of convertible securities to change the control of listed shell in substance, etc, in which case the transaction shall be treated as if a reverse takeover, unless the assets acquired meet the profit requirements set out in Rule 8.05 of the Listing Rules.
In case even the very substantial acquisition is not considered as an extreme case, the Exchange has adopted an enhanced disclosure and vetting procedure for the listed company for which the listed company has to publish announcement and circular disclosing the transaction. Also, a financial advisor has to be appointed to conduct due diligence for the transaction.
In addition, the Exchange is of the opinion that the two bright line tests are not exhaustive whereby transaction considered as backdoor listing shall be treated as reverse takeover. In Listing Decision LD95-2-2010, the Exchange agreed that bright line tests were not applicable and there was concluded no change in control. However, the Exchange ruled that such transactions were designed to get around listing procedure and was deemed as an extreme case.
Aside from this, the Exchange adopted a more stringent approach on reverse takeover that it has been considering to implement a robust regulation to delist those listed companies without any operation of business and being suspended for a certain time. The ultimate aim of the Exchange is to provide the market with clarity and certainty in respect of its attitude towards backdoor listing by reverse takeover transactions.
In US, there are many Chinese companies buying listed shell companies to get around the rigorous disclosure requirements for IPO. It is now regulated that every companies listed by way of reverse takeover should be subject to a rebuttable presumption that its equity share should be suspended from trading. This regulation shall protect the investor from investment on listed company with problems in terms of disclosure and minority shareholder issues. It was submitted that this approach can tackle the reverse takeover issue existed with opportunism.
In China, any takeover of offshore companies should be approved by Ministry of Commerce under Circular numbered 10. In 2011, China Securities Regulatory Commission promulgated the Amendments to Administrative Measures for the Restructuring of Material Assets of Listed Companies whereby higher thresholds for reverse takeover have been adopted to tighten backdoor listing by reverse takeover. In addition, particular types of companies such as venture capital corporate shall be subject to different sets of rules for backdoor listing.
All in all, the cost for compliance and transaction in respect of reverse takeover shall jump accordingly in different jurisdictions.
V CONCLUSION
Invariably, there is always no one single theory fits and satisfies all circumstances, different theories might explain different types of takeovers and reverse takeovers. Management of a company decides every corporate transaction, including takeover and reverse takeover, with the aim to maximise the wealth of shareholder, if not only expanding the power, according to Value Maximisation theory.
However, research and studies show that conventional theory of Value Maximisation to explain reverse takeover in the financial perspective is discounted while Empire Building as an attribution is gaining attention. The author suggests that reverse takeover cannot only be explained by theories of Value Maximisation and Empire Building, backdoor listing under this way should be taken into account of any opportunity exposed to the acquirer and Opportunism comes to play a prominent role for such transaction.
Viewed as a whole, reverse takeover indeed provide an alternative route for company to gain listing status in a cost and time effective way. To the extent that the Exchange forms a view of absence of circumvention of new listing requirements, the management of potential acquirer and practitioners should always bear in mind this opportunity as an effective way to expand the fund raising channel.
Provided that the regulations on reverse takeover become more and more stringent, practitioners should also advice the acquirer for any cost for regulation and due diligence and the risk of challenge posed by the Exchange.
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