Arnab Moitra International Management Institute, New Delhi REVERSE MERGERS Alternatives to going public
Jul 19, 2015
Arnab Moitra
International Management Institute,
New Delhi
REVERSE MERGERS
Alternatives to going public
WHAT IS A REVERSE MERGER?
• A reverse merger transaction (or reverse takeover) generally involves two firms, one publicly listed firm and one private firm seeking public listing
• The public firm is usually only a “shell” company i.e., it has no or only nominal assets, and is merely listed on an exchange
• Shells formed from scratch specifically to engage in a merger or acquisitions are called “blank check companies”
• Shells resulting from the sale or liquidation of an operating public company are called “public shells”
• The private company’s shareholders generally receive between 65% and 95% of the public shell’s stock, gaining a controlling stake
• The public firm contains the operating assets and liabilities of the private company and retains its stock exchange listing
FACTORS AFFECTING VALUATION
• This is primarily dependent on how recently an operating business existed in the shell
“Cleanliness” of the shell
• A start-up will retain less of the merged company than a sales-generating company with $1 million in earnings
Valuation of the private company merging in
• Cash in the shell increases the shell’s value
Cash
• The value of the shell will improve if those managing the shell have reputable backgrounds
Shell management
STEPS TO A REVERSE MERGER
1• The public shell (“ShellCo”) forms a new, wholly-owned empty subsidiary (“Merger Sub”)
2• Merger Sub then merges into the private operating company (“OpCo”)
3
• OpCo’s shares are converted into shares of ShellCo constituting a majority stake in ShellCo(typically an 65 to 95 percent stake)
4• OpCo is a wholly-owned subsidiary of ShellCo
5• OpCo’s former shareholders own a majority of the outstanding shares of ShellCo
WHY NOW?
• Since 2001 the IPO market has been effectively shut down for all but the largest private companies
• Private equity markets for growing private companies have been soft making it tough to grow
• The PIPE market has been experiencing tremendous growth and creating more potential benefits if access to the capital markets is important
• M&A market had been very weak therefore limiting the exit options that entrepreneurs and investors have had
• PIPE investments now more closely resemble “true” longer-term investments
• New regulation mandating a significant increase in the amount of disclosure immediately following most reverse mergers
ADVANTAGES OF BEING PUBLIC
• Investors have sufficient information available in public filings, easier and faster exit options and a higher valuation for a public company
Access to capital
• Owners, entrepreneurs, and prior investors have a way to cash out, assuming there is an active trading market in the stock
Liquidity
• A public company can use its stock as currency or “scrip” for acquisitions, preserving needed cash for other uses
Growth through acquisitions or strategic partnerships
• Stock options encourage staff to perform well and vesting of options promotes long-term commitment to the company
Stock options to incentivize
• Financial and other results become publicly known and changes in performance need to be explained
Management is much more answerable to its owners
ADVANTAGES OF A RM OVER AN IPO
• Involves much lower cost
• A much speedier process
• A private company is not subject to watching the IPO “window”
• There is no risk of withdrawal
• Management attention is much less than in an IPO
• RMs experience lower dilution of ownership control
• RMs lack an underwriter
DISADVANTAGES OF A RM OVER AN IPO
• In many cases the extra money to be raised in an IPO simply is not needed
• After going public in a reverse merger, a company can proceed with a larger, IPO-size secondary offering
Less funding obtained in a reverse merger than an IPO
• After an IPO, underwriters work to support the stock and keep it trading at a reasonable level
• This is not the way a healthy stock market should develop
• The post-IPO market support tends to remain only long enough to protect the underwriters and their initial investors
Obtaining market support following a reverse merger is challenging
CHINESE REVERSE MERGERS
A comparison between Chinese RMs and Chinese
IPOs
CHINESE RMS AND CHINESE IPOS (1/3)
The average total assets of CRMs are about 14 times smaller than those of Chinese IPOs
However, the average total assets of CRMs between 2005 and 2010 were 3 times smaller
than those for the Chinese IPOs
There was a slowdown in Chinese IPOs during the financial crisis in the U.S. in 2008 and
2009, but CRMs remained relatively unaffected
Thus, reverse mergers are more resilient that IPO markets and appear to offer a more
stable option of cross-listing on U.S. exchanges
CHINESE RMS AND CHINESE IPOS (2/3)
Table shows the breakdown of CRMs and Chinese IPOs by state of incorporation
Majority of Chinese IPOs are not incorporated in the U.S.
Only four Chinese IPOs are incorporated in Delaware
Out of the 100 CRMs, 27 are incorporated in Nevada, 18 in Delaware, and 45 outside the
U.S. (mostly in China and the Cayman Islands).
CHINESE RMS AND CHINESE IPOS (3/3)
#3 involved 21 CRMs, followed by #6 with 15 CRMs
The Chinese IPOs were concentrated in two industries – 42 in #6, and 35 in #12
However, the majority of the assets of the Chinese IPOs were #4 and #7
FIRM FEATURES 1 YEAR AFTER LISTING (1/2)
The avg. size of Chinese IPOs exceeds the avg. size of CRMs by a factor of 14.
CRMs are smaller in size than Chinese IPOs, and indicates that an IPO may not be an option
for all firms seeking cross-listing in the U.S.
The median Tobin’s Q is significantly lower for CRMs, which indicates that the typical Chinese
IPO has higher growth options, but the avg. Q is similar between the two samples
Therefore, we find mixed evidence that growth opportunities are related to the choice between
a reverse merger and an IPO
Financial leverage of CRMs is significantly higher than that of Chinese IPOs by a factor of
approximately two
FIRM FEATURES 1 YEAR AFTER LISTING (2/2)
The higher leverage of CRMs indicates that they were able to raise capital in form of debt
The operating performance of CRMs is comparable to Chinese IPOs
Chinese IPOs spend a statistically significantly higher amount on R&D per dollar of total assets,
but the average amount spent on Capex is marginally lower than for CRMs
Thus, firms with higher R&D expenditures are more likely to pursue an IPO, and are thus likely
to fund future growth opportunities
However, other capital expenditures do not affect the choice between reverse mergers and IPO
CUMULATIVE AVERAGE TOTAL RETURNS
Figure shows the cumulative average total return of CRMs, Chinese IPOs, and S&P 500
firms between June 30, 2008 and June 30, 2011
CRM and Chinese IPO performance metrics moved in tandem until early 2011, after
which the CRMs underperformed the Chinese IPOs
It shows that had an investor purchased the basket of CRMs in June 2008, the investor
would have lost 49% compared to a gain of 3% on the S&P 500
INCIDENTS OF LITIGATION
From January 2001 through April 2012, the figure shows an increased frequency of
securities class action activity after 2010 involving CRMs relative to Chinese IPOs
FIRMS UNDER SCRUTINY
CHINESE RM SETTLEMENTS
THE INDIAN EXPERIENCE
The case of ICICI Bank and Westlife Development
ICICI BANK
• ICICI was formed in 1955 as the initiatives of the World Bank, the GoI and representatives of Indian industry with the objective to create a development financial institution
• In 1990, ICICI transformed its activities to a diversified financial services group with the offering of the wide variety of products and services, both directly and through multiple subsidiaries and affiliates like ICICI Bank
• The competitive scenario in the Indian banking industry and the goal of universal banking was the precursor to the merger of ICICI with ICICI Bank
• In October 2001, the Board of Directors approved the reverse merger of ICICI and two of its wholly-owned retail finance subsidiaries, ICICI Capital Services Limited and ICICI Personal Financial Services Limited with ICICI Bank
• The merger had got approval from the shareholders of ICICI and ICICI Bank in January 2002 and the Reserve Bank of India in April 2002
• After this merger, the ICICI group's financing and banking operations, both wholesale and retail, have been integrated in a single entity
WESTLIFE DEVELOPMENT
Hardcastle Restaurants is the west and south India franchisee for American
burger chain McDonald's
Westlife Development’s shares rose75% in virtually three trading days after
McDonalds' franchisee Hardcastle Restaurants became its direct subsidiary
The shares closed at Rs 153.90 on the BSE on December 12, 2012, up from
Rs 86.20 on December 7, 2012, when the non-banking finance company
announced the reverse merger
CONCLUSION
• A reverse merger does not raise new capital for either the public shell or the private firm
• However, they are structured to raise capital via a simultaneous PIPE financing option
• With a weak IPO market, a RM is more attractive to middle-market businesses
• Chinese RM firms are substantially smaller in terms of assets, have higher leverage, have lower analyst and institutional following, and face a higher probability of a class action lawsuit
• Despite the lower up-front cost, Chinese RMs attract more class action litigation and experience significant underperformance once their stocks get listed
• An added unobservable cost of Chinese RMs may be related to a “lemon” problem – even reputable firms face higher costs of doing business as a result of being pooled together with less reputable firms