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Friday / March 24.

Know Your Jargon

By Chaahat Khattar

Edited by Shambhavi Singh, Senior Editor, The Indian Economist

Hostile Takeover:

Takeover is defined as an act of assuming control of something, especially the buying out of one company by another. There are several types of takeovers such as Friendly Takeover (approved by the management of all the parties involved), Reverse Takeover (takeover of a public company by a private company because of a stronger brand name, but a weak balance sheet of the public company. One globally renowned example of reverse takeover is acquisition of US Airways by America West Airlines to save the former from bankruptcy), Backflip Takeover (an unusual takeover strategy in which the acquiring company turns itself into subsidiary of the purchased company. Texas Air Corporation became a subsidiary of Continental Airlines after acquiring it) and then there is Hostile Takeover in which the suitor or the acquirer takes over the target company whose management is unwilling towards the merger or takeover. It is said to be hostile as the board and the management of the target company continues to oppose it while the acquirer pursues to buy out the majority shareholding of the company. Hostile takeover is one of the major risks a company faces as it floats more than 50% of its equity in public. There are ways to make hostile takeovers possible. One common way is to tender a price to the target company above the market price so that the target company can give it a thought. The second method includes going to the shareholders and attaining simple majority so that the old management can be replaced easily. In both the methods the management does not like it but it is still carried out. There is another method known as the tender creeping offer in which the acquirer buys enough shares from the market so that a change can be made in the targeted company.

Ways to defend against a hostile takeover are:

  • The Golden Parachuteis a provision in a CEO’s contract. It states that he will get a large bonus in cash or stock if the company is acquired. This makes the acquisition more expensive and less attractive. Unfortunately, it also means that a CEO can do a terrible job of running a company, make it very attractive for someone who wants to acquire it, and receive a huge financial reward.
  • The supermajority is a defense that requires 70 or 80 percent of shareholders to approve of any acquisition. This makes it much more difficult for someone to conduct a takeover by buying enough stock for a controlling interest.
  • staggered board of directors drags out the takeover process by preventing the entire board from being replaced at the same time. The terms are staggered, so that some members are elected every two years, while others are elected every four. Many companies that are interested in making an acquisition don’t want to wait four years for the board to turn over.
  • Dual-class stock allows company owners to hold onto voting stock, while the company issues stock with little or no voting rights to the public. So, the investors can purchase stocks, but they can’t purchase control of the company.

Apart from such conventional defensive strategies, hostile takeover can be avoided in case the high-level managers threaten to leave the company if acquired, target company sells off its research and development division (crown jewels) and floats it into another making the target company less attractive, allowing current shareholders to buy shares of the target company at steep discount rates or taking a really large amounts of debt making it difficult of acquirer to pay off.

Credit Default Swaps:

Credit default swaps, or CDS, are insurance against the risk of default on a debt (such as loan, bond etc.).

By the virtue of its name, Credit Default Swaps refer to as the process or way of swapping credit policies for a sum payable on the default of the credit (it can also be understood as the insurance for financial instruments). International banks started layering low-grade loans/credit obligations of borrowers (layered products were given fancy names such as Collateral Debt Obligations or “CDOs”) and sold them in open markets (this process of deregulated banking was also known as Shadow Banking which referred to financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight). Alongside, banks understood that such credit is trash hence they took insurance for the same from companies such as American International Group (A.I.G).  Since banks had nothing to lose (instead they were making billions of dollars), they started buying more of CDOs to trade. For this ponzi scheme, banks borrowed more and more money from the market which now leads us to the concept of leverage. Leverage is the ratio between bank’s borrowed funds and own funds (also known as Debt to Equity Ratio). When the trading of CDOs was sky rocketing, leverage of several investment banks which later collapsed rose to the levels of 33 to 1. This means that banks had 33 times more borrowed funds on their books than their own funds. Solving this with the help of an example,

Suppose a firm has a leverage of 33 to 1 where,

Debt= USD 33,000

Equity= USD 1,000

Leverage being= 33,000/1,000= 3:1

We know Total Assets= Equity + Debt

Therefore, Total Assets= USD 34,000

This is a dangerous and really horrifying figure. If for some reason, bank’s assets decrease by a mere 3% (34,000 * 3%= USD 1,020), it will be insolvent (Total Assets now are worth 34,000 – 1,020= USD 32,980 which is less than the total debt of the bank). When the layered financial instruments such as CDOs defaulted, banks lost nothing but insurance firms like AIG had to pay the insurance to the banks otherwise banks would have run out of cash to pay for their obligations.

But soon after more and more CDOs defaulted, banks lost their liquidity and AIG obviously had paid out enough that it also went under cash crunch soon after leading to a systemic and malignant failure of US economy.

Daisy Chain:

Daisy Chain is the Manipulation of the market by traders to create the illusion of active volume to attract investors.

A daisy chain is a term used to describe a group of investors who engage in activities that inflate or deflate the price of a stock for the purpose of selling it for profit or buying it cheaply. Daisy chaining involves creating transactions to make a particular stock appear more active than it actually is. One way people engage in daisy chaining is by buying securities at low prices, passing the securities through other brokers at prearranged higher prices and buying back the securities at higher prices at the end of the day.

For example, in a classic daisy chain, Broker A buys a stock at $40 and sells the stock for $45 to Broker B, a daisy chain member. Broker B then sells the stock for $50 to another broker on the chain. At the end of the day, Broker A buys the stock back at $50. Thus, for someone outside of the chain, the stock price looks like a good investment because it climbed from $40 to $50 in a single day.

Investors who come into the market buy the stock at $50 and the brokers who are a part of the daisy chain sell it for $50. While the daisy chain brokers may profit from these falsely boosted transactions, manufactured transactions of this kind hamper the natural flow of activity for securities and can be dangerous for investors.

Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller. He has keen interest and experience in authoring research papers and case studies and have contributed to various renowned journals. Chaahat can be reached at [email protected]