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|ANATOMY OF THE CORPORATE TAKEOVER|
|Cartoons in this series by Gordon Collins|
a recent poll of 47 Canadian managers representing a broad cross-section
of industry - 60 per cent estimated that more than 70 per cent of Canadian
industry was now owned and controlled by foreign corporations. Another
50 per cent agreed that this massive takeover of industry would not
have been possible without the inside help of Canadian managers. Furthermore
In spite of these judgement or attitudes, 75 per cent were of the opinion that Canadian management had not 'failed in its responsibility to society at large' which seems a contradiction when balanced with all the other statistics, but is not. The reason this is the subject of this essay. A more startling fact came to light when 70 per cent admitted that they were unaware of the difference between bonding and equity capital.
TWO KINDS OF INVESTMENT
For the benefit of readers not familiar with these two kinds of investment, bonding and equity, appreciating the function of each type of investment is essential to any understanding of the mechanics of the corporate takeover.
Bonding capital buys the investor a guaranteed return of any investment at a fixed rate of interest over a given time period. A government savings bond is a good example of this type of investment. While the recipient of the bond has certain rights, a share in the ownership of the enterprise into which the money is put is not one of them. Conversely, equity capital buys the investor ownership - or a share of it depending on the amount invested - but with no guarantee of return. People who buy common stock through a stock broker are equity investors. They receive voting power equal to the number of shares owned. In the case of bond investment the risk to the investor is low in relative terms; the degree of risk to the equity investor, on the other hand, is high, again, relatively. Hence the term, risk capital. There are other differences between the two types of investment, but none which need concern us here.
The point to be made here is that as the majority of managers surveyed admitted ignorance of bonding and equity capital, it is no wonder so few people understand the mechanics of the corporate takeover. It is equally hard for the public to appreciate that many concerns are 'gobbled up' with no more than the exchange of two, otherwise worthless, pieces of paper. People may think that when one company is taken over by another there is an exchange of money. Nothing could be further from the truth. In the majority of cases no real money passes from the buyers to the seller as happens when, for example, a housewife buys weekly groceries at the supermarket. In corporate takeovers, a sort of trans action takes place, but it is rather like the seller being handed a cheque drawn on their own bank account. This may sound crazy and illogical; it is. Nevertheless, that is what happens.
How does this process work? The is easy to understand once one has grasped a few simple principles. In the first place, successful takeovers or acquisitions as they are sometimes termed stem from the avarice of shareholders; those who hold shares of common stock. More importantly, acquisitions are rarely possible without the collusion and active help of senior executives of the enterprise to be acquired. Finally, given the average team of smart corporate executives, meaning those intent on doing the acquiring, together with the inside help, makes for a winning combination.
A TYPICAL CASE
To illustrate how the system works, as well as to measure the after-effects of a corporate takeover, let us consider a hypothetical case. First, let us provide our corporation and the company to be acquired with fictitious names. We obviously would not wish to find ourselves with a court case on our hands for impinging the fair image of some unworthy corporation.
Let us introduce then the Romeo Corporation, a foreign-owned conglomerate, an organization, that is, with numerous mergers under its corporate belt and having, therefore, a diversity of interests. Romeo shares are currently listed on the New York Stock Exchange at $40 a share. In the parlance of the marketplace, its liquid position is weak, which is to say that even though it is a multimillion dollar corporation it has practically out of ready cash or, as is said, good liquidity. Despite having empty coffers, its stock is at an all-time high. What is more, it has three million un-issued common shares registered with the U.S. Securities and Exchange Commission. The actual shares don't exist. They are merely registered, but can be printed up in short order as necessary.
The logical question then to ask is why not print three million shares and sell them each at $40? That is too simple a question to answer. They would merely flood the market and depress the stock price. Then where would the corporation be? No, it is better to leave them where they are. They will be put to use all in good time. One thing we must not forget is that Romeo Corporation enjoys a good public image; its vice-president of public relations boasts that the corporation is a 'good' corporate citizen, whatever that means. My own interpretation of the good corporate citizen is one that has never had a public scandal; never washes its dirty linen in public; has never been cited for contributing to pollution of the environment; has never entertained unseemly demonstrations at its annual general meeting and so on and so forth. In fact, it strikes one that good corporate citizens stand on a firm base of negativeness. As to its business performance, Romeo Corporation's earnings amounted to $2 per share over the past year of operations and, of this, the board of directors voted to pay shareholders a dividend of $1 per share. All round, an excellent performance.
What do these figures mean in terms of Romeo Corporation's PE ration? If we use the letter P to denote the current price for which a share may be bought on the open market ($40) and the letter E to denote the earnings ($2) per share, we can calculate what is called the PE ratio by dividing the one by the other; that is
The higher the ratio the higher is the confidence of the investing community in a particular stock. Many enterprises have PE ratios in excess of 20:1. Stocks with PE ratios in the highest range are often labelled 'Glamour Stocks'. Expressed another way, stocks with high ratios are considered to have 'growth potential'. As a consequence, stocks in this category may be expected to yield high dividends at some future date. At the other end of the scale a business with a low PE ratio does not have a high standing in the eyes of the investing community relative, that is, to those higher in the scale.
Established, solid concerns with little or no growth potential fall into the latter category. They may pay generous dividends in comparison with the stock value because they tend to be managed by conservative people. Such enterprise are likely to have large reserves of cash in their bank accounts, which is to say they enjoy strong liquidity. Furthermore, that type of concern by the very nature of its image - strong liquid position, low PE ratio and conservative management - is ripe for takeover. Why this should be so I don't truthfully know, but it is a common characteristic of acquired companies.
The Juliet Manufacturing Company, about to become a text-book example, is typical of the kind of concern described: pedestrian, conservative management, regular dividends to stockholders, high liquidity. What do we know about it? First, that it is a public company with shares listed on the Toronto Stock Exchange, currently selling for $20 a share. Its earnings stand at $2 per share. The company pays an annual dividend of 50c per share. Its PE ratio is therefore:
The company does a gross business in the order of $7m. The outlook seems bright, safe and secure. The management operates an employee profit-sharing plan; it has a generous pension fund; a non-contributory insurance plan lodged with a Canadian Trust company; there is a full order book; its export business is booming; there are good management-labour relations. In short, Juliet Manufacturing Company is a good corporate citizen in every respect. However, unknown to Juliet Manufacturing, her fat bank balance and her future are the subject of discussion by Romeo Corporation executives sitting in their ivory tower a thousand or more miles away.
Much of Romeo Corp's growth as earlier intimated comes from the acquisition of smaller, established concerns. It sharp corporate executive is constantly on the lookout for suitable businesses to acquire and, recently you've guessed correctly its corporate eyes have settled on Juliet, small, juicy and ripe for the plucking. So it comes to pass that the president of Juliet Manufacturing receives an invitation to attend a private luncheon party. He is possibly already known to Romeo Corporation's executives through normal business contacts.
Whatever the case, he accepts the invitation and finds himself in the company of perhaps two or three gentlemen, no more, who just happen to be visiting the area. During the course of the meal, someone suggests that a merger of their two concerns might be to their mutual advantage. The merger, it is intimated, would take place on a share for share basis, or something after that fashion. This means Juliet Manufacturing shareholders would exchange their share, one for one, with those of Romeo Corp. These, they point out, are worth $40 a share as compared with Juliet's $20. In addition, Romeo dividends are twice what Juliet pays ($1 as opposed to 50c). It is an interesting proposition like love at first sight.
A VARIETY OF BAIT
There would be other advantages, including higher salaries for the executive officers - to say nothing of the incentive bonus - increased purchasing power for the smaller company in that it would have the advantage of bulk purchases made by Romeo Corp., greater stability during the lean periods, lower prices for goods manufactured within the Romeo group of companies and, as a consequence, a price edge over the competition. To clinch the deal, Romeo Corporation would pay the president of Juliet Manufacturing Company a $150,000 annuity, payable at the rate of $30,000 a year over the next five years - for services rendered.
The carrot is a large one. Who could resist? In summary the stockholders would double their share value; dividends will increase twofold; the president would get a fat annuity; and there are all the concrete benefits of an 'upward merger' for Juliet Manufacturing. Romeo Corp. begins to look like a philanthropic foundation. There is no mention of the benefits that will accrue for that organization. However, this is the general line of reasoning used to persuade the president of Juliet Manufacturing.
Obviously, the form and tactics will vary from situation to situation. They will undoubtedly be more subtle than what I have described. For instance, there would be a number of meetings. There might well be more than one Juliet official involved; people would have to be 'sounded out' and so on and so forth. Progress would certainly be reported back to the Romeo ivory tower and plans made to persuade Juliet's shareholders through its board of directors. Takeovers, it will be understood, are planned and executed in meticulous detail.
Now let us suppose that Romeo and Juliet decide to get hitched. Romeo has no actual money to pay for the acquisition remember. No trouble. They have those three million un-issued shares of common stock registered with the U. S. Securities and Exchange Commission, which would be released for the asking. Permission being granted, letters are sent to all registered shareholders (with proxy forms enclosed for their convenience, of course). The requisite number of votes will already have been mustered for the 'extraordinary' general meeting, convened to satisfy the demands of corporate law.
The extraordinary general meeting is the corporate equivalent of a marriage feast, and what a delightful affair it turns out to be. The 'merger' resolution is proposed, seconded and accepted by the shareholders with only a few dissenting votes - included for form's sake. There are speeches, handshakes, expressions of warmth and congratulations; everyone is smiling and gay. Cocktails follow. Juliet's senior executives and directors appear demure and maiden-like. The Romeo people present, meanwhile, positively ooze with charm.
THE UNION IS CONSUMMATED
In no time, the deed is done. In our mind's eye, we see Romeo bear his Juliet away to the bridal chamber. He has every reason to feel triumphant for he has not only improved his equity position, growth has been achieved. There is every reason to suppose, as with all successful marriages, they will merge and become as one.
The after-effects do not begin to be felt until some time later. First there are a few innocuous directives, aimed at bringing Juliet Manufacturing financial statements into line with the 'corporate' practice. There are others, seeking conformity in labour and production reports. The Juliet management is only too anxious to oblige in the new spirit of cooperation. As time goes by, corporate 'specialists', management experts, planners, vice-presidents of labour relations and the rest make an appearance at the offices of the newly-acquired concern. Management 'teams' are expensive; they must be paid for their services, naturally, and Juliet Manufacturing finds itself faced with bills for management fees.
This is a perfectly legitimate practice, but, added to the large contribution needed to 'pay' the president's fat annuity, substantial inroads are made into Juliet's bank balance. However, there is no argument. How can there be? The company has been absorbed and its management, through its board of directors (maintained for ceremonial purposes), is no longer responsible to shareholders but rather to a higher corporate management. The corporate fee becomes a regular liability. The liquid assets Juliet Manufacturing enjoyed in the days of independence quickly drain away. When there is no more in the pot, the corporate management fee, which must now be met, is front-end loaded. That is to say, the fee becomes part of the fixed operating expenses along with depreciation, maintenance costs, local taxes, hydro services and the rest.
To cope with this added burden, the goods Juliet Manufacturing produces must be sold at higher prices. Alternatively, it must cut costs in other directions and accept lower profits to meet competition. As a side issue, profits do not assume the same importance they had when Juliet enjoyed complete autonomy. This is hard to believe, but is nevertheless true. The enterprise still receive about the same income for their goods and services as formerly. As explained, however, costs have increased by reason of the corporate overheads. Lower profits actually mean they now pay a smaller corporate tax to the government, which is advantageous, isn't it?
In an effort to reduce costs, the first thing to go is the profit-sharing scheme, superficially discontinued on the volition of Juliet's management but, in fact, it would have been part of the 'merger' conditions imposed by Romeo Corporation. Next, the pension plan, insurance scheme and other 'fringe benefits' are transferred from the Canadian trust company to an American equivalent of Romeo Corporation's choice. This practice, incidentally, is yet another of the hidden devices for transferring capital. Yet again, to further improve Juliet's weakening liquid position, its management is instructed to operate on a smaller inventory. If, for example, Juliet Manufacturing maintains a raw material and finished goods inventory of 1 million dollars, and reduces this by half, then $500,000 must find its way into the bank account and become a liquid asset. This process is known as 'liquidating the inventory'. Another common practice is to withhold funds to meet depreciation of plant and equipment. Every factory, if its management is to maintain up-to-date equipment, must replace worn-out machines. In other words, funds at least equal to the amount of annual depreciation must be spent on replacement machinery.
Remember, no real money changed hands when Juliet Manufacturing was taken over. It is true that the shareholders doubled their money and the president was handsomely rewarded, but someone had to pay for the acquisition. There is only one solution to what appears at first sight a total mystery and our first guess has to be the right one: the consumer and taxpayer pay the cost, of course. Yes! ultimately it is the public who pays the public has to. It is a matter of simple economics.
When one concern takes over another, in the vast majority of cases it does so for powerfully selfish reasons. In the case of foreign-based corporations, there is unquestionably a flow of funds out of the country and this movement of capital. This is robbery on a grand scale. There is no honour, no high-flown motives, no concern for the paying public attached to corporate acquisitions. It is thievery at the executive level, pure and simple, whatever palatable euphemisms are used to disguise the practice. A short time ago a man in the City of Toronto stole something less than fifty cents from an open newspaper rack. He was detained in jail for two weeks because he was unable to raise a $25 bail. When one compares his crime with the monstrous crime of corporate takeovers, which occur every other week, it makes one wonder where justice is sleeping.
These are just a few of the ways by which a company's assets may be liquidated. If corporate fees and other similar devices for siphoning-off cash are not sufficient to reduce Juliet's liquid position to a bare operating level, Romeo Corp. can always 'borrow' funds at ridiculously low interest rates. This is often done. I am talking about interest rates of 3% or less, and who is to say a parent company may not borrow at the rate of interest it chooses to set? In fact, all these devices are the tools of a deliberate policy on the part of Romeo Corp. to improve its cash flow. It is on this aspect of the corporate takeover that one must judge the phenomenon of the conglomerate.
In my opinion, and surely in the opinion of anyone who claims to be a thinking person, the practice of corporate acquisitions is an invidious one. It is safe to say that in the vast majority of cases they are carried out without any real concern for the welfare of employees or for the good of society at large. Employees are far better off under the management of the smaller, closer-knit enterprise. As for society, one of its benefits comes from corporation taxes which are actually diminished when smaller concerns are acquired by large corporations.
For the reasons given, our politicians must share with corporate executives an equal burden of guilt, for they are not so stupid or naive as not to know what goes on. What is more, they have the power to prevent such flagrant abuse of ethical behaviour. In the absence of proposals from political quarters (commissions, parliamentary sub-committees et al) to curb and control this type of crime, one might advocate these measures:
In considering this admittedly difficult problem, our legislators would do well to study the Mexican and Italian models, for both those countries in recent years having tackled and substantially solved their foreign ownership problems.
Finally, to return to the apparent contradiction cited at the outset of this essay, there is a very good reason why 75 per cent of the managers questioned did not feel Canadian management had 'failed in its responsibility to society at large'. With the exception of top executives, the rank and file management is as much at a loss to understand the mechanics of the corporate takeover as the man in the street. If they did know they would surely have answered the question differently.
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