5.8. An example of corporate governance – Russian preferred shares

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From the course by Moscow Institute of Physics and Technology

Mergers and Acquisitions – The Relentless Pursuit of Synergy

1 rating

Moscow Institute of Physics and Technology

Mergers and Acquisitions – The Relentless Pursuit of Synergy

1 rating

Course 4 of 5 in the Specialization Understanding Modern Finance

The area of mergers and acquisitions (M&As) is special in finance. Incredible amounts of money are employed in such transactions. Deals draw a lot of public attention and dispute. Oftentimes, stories look more like fairy tales rather than financial reality. The key idea in any M&A transaction is to create value through a potentially synergetic activity. To this end, it is important to have a clear motive and implementation plan. Of special importance are the correct valuation, proper financing, and actual deal completion. But this is not the end – value mostly accrues from the post-merger integration. The understanding of the motives of various stakeholders is instrumental in the analysis of the potential creation of value. The learners will gain insight into the core value creating M&A strategies. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. Finally, the Course is very helpful in successful completion of the Specialization’s Final Project.

From the lesson

Value-Creating Strategies. Anti-Takeover Defenses. Corporate Governance and Performance. Conclusions – the Relentless Pursuit of Value

Week 5 – the final week of the Course – focuses on the details of value creating strategies. We start with share repurchases and their effect on value. Then we analyze anti-takeover defenses as value creating strategies. We proceed with the discussion of corporate governance. Although in M&As this concept has somewhat narrower meaning, we try to relate the advantages and costs of a well-functioning and efficient corporate governance system to the development of the M&A market. On a specific example we analyze the potentially value-destroying conflicts that may arise from the underdeveloped corporate governance system. Finally, we identify the role of post-transaction merger integration in the creation of value. We provide some conclusions on M&A efficiency and synergy. At the very end, we summarize the Course and the Specialization and briefly discuss the Final Project.

5.1. Value creating strategies4:45

5.2. Share repurchases. Fixed-price tender offers14:29

5.3. Anti-takeover defenses (1) – returns to bidders and targets10:10

5.4. Anti-takeover defenses (2) – pre-offer defenses8:41

5.5. Anti-takeover defenses (3) – post-offer defenses9:24

5.6. Corporate governance in the US – an overview18:14

5.7. Corporate governance in other countries – who will pay?9:59

5.8. An example of corporate governance – Russian preferred shares9:19

5.9. Implementation and integration – key to success5:16

5.10. Some conclusions – the relentless pursuit of synergy7:28

5.11. Summary of the Specialization. Overview of the Project5:46

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Well, in order to save our time,

I prepared the background for you.

So, the story is that Russian preferred shares,

they are sort of special financial instruments.

And again, the country's free market is sort of very young.

The process of privatization was started as late as in 1991 and again at

that time there was an idea that because formerly,

all the enterprises were state-owned.

Then during the process of privatization they said, "well,

why wouldn't we give preferred stock to the employees as the weakest,

the least educated, the least understanding of

what's going on in the capital markets that are being born?"

And again, they said

the 25 percent of share capital will distributed among these workers and

the minimum dividend to the preferred shareholder would

be 10 percent of net income and no less than common dividend,

whatever happens to the net income number.

So again, that was

a classic case of a good intention and you know that the road to hell is paved with them.

And as a result,

what I will show on the next pages of flip chart is that

the misunderstanding at that time or what could

happen resulted in some fundamental conflicts of interests and

the potential negative effect on the investments and the investment climate.

So if we kept that in mind then here,

I show you the preferred shares cash flow story.

So if this is the cash flow as a percent of net income and this dividend per share,

well, I wouldn't put any numbers here,

it can be shown that if we have 25 percent of preferred

and if the preferred dividend

is at least 10 percent of net income,

then we see the folly chart.

Then if cash flow available to equity investors is less than 40 percent of net income,

this is this area, then preferred dividend is higher than the common dividend.

We can see the preferred cash flow,

which is here in the red,

is always greater or equal to common cash flow which is here.

And again, cash flow if it's

less than 10 percent you know that nothing goes to common dividend because

all of that goes to preferred dividends.

So here clearly the preferred cash flow is higher and therefore,

we can expect that preferred shares should be always

more expensive on the market than common shareholders.

But again this is a chart from 20 years ago but it

was shown that actually the market valued them completely differently.

The discount to common was somewhere from 20 percent at the times

of the most liquid and active market and up to 50

percent at times when markets were sort of turmoiled.

So, we see the obvious contradiction.

Something that must be more expensive is actually cheaper.

So that's poses a big question and this is, so we say, why?

And then the next page I will show you the gross of simplified case

that supports the following very strange idea

that given the structure of Russian preferred shares it can be shown that in perpetuity,

all returns they are being pocketed by preferred shareholders.

So the case goes like this.

Let's say that if return on invested capital is

10 percent and he preferreds will be just 10 percent not 25.

By the way, if the rate is lower than 25 then the dividend is prorated to that.

Now, commons, 90 percent and the minimum dividend 10 percent of net income as required.

So, in year zero what do we have here?

We have the initial invested capital,

90 comes from common shareholders,

10 comes from preferred shareholders.

Now this 100 is invested and produces a ten dollar return.

Now this is the same capital that travels here in

year one but then here we have 110 altogether.

But of this ten,

one dollar is a 10 percent preferred dividend and then, let's say,

for suppose the nine dollars is being reinvested,

so we end up the first year with a falling numbers.

This part which is total invested capital is now

109 and then the preferred dividend of one dollar.

Let's see what are the returns.

We start with the return for commons.

This is 90 percent of this,

90 percent of 109,

and if you divide that by 90,

the initial investment you will see that the return is nine percent.

Well, so far so good.

Well, this is kind of lower than the return on invested capital.

So the difference must be pocketed by whom?

Well, by preferred shareholders.

Why? Because now preferred shareholders,

they have 10 percent of 109 that is indeed at the same nine percent return.

But they have a cash dividend of one dollar

which is another 10 percent on their investment.

So the total return to preferred shareholders is

19 percent which is more than double the return on commons.

And it can be shown that if we preceded then

all value in perpetuity accrues to preferred shareholders.

So, that is clearly a huge conflict of interest because

these guys are decision makers and these guys are the value pocketers.

So we can see this conflict of interest,

a value accruing to preferred shareholders but at

the same time and now we have an explanation to the chart that we've seen up there.

That is because preferred shareholders did not engage.

They did not enjoy legal protection.

For example, common shareholders could also vote on any issues

regarding preferred shareholders and in order to have a decision confirmed,

they needed 75 percent but not of

all shareholders but of those present that the shareholders meeting.

And we mentioned before that

preferred shareholders were just workers at these enterprises.

They were the least likely to show up at these meetings and therefore, there was,

I'm showing just one case where

the legal protection of preferred shareholders could have been abused.

And there were dozens of others, for example,

you could play with the number of this net income.

Because at that time

the Russian Accounting Standards

were very far from the International Accounting Standards.

Now it's much better.

That's why I'm studying this case sort of against

the background of what was 20 years ago.

And as a result,

these multiple abuses, they did take place and therefore,

we could see that common shareholders could have been deprived of

their value if they kept honouring the rights or preferred shareholders.

But that would be against their vested interest.

And therefore, we can see that lack of

good corporate governance that not only resulted in this conflict of interest

but it negatively affected

the overall investment climate and it resulted in under-investment.

Well, at that time we even offered some

speculative of strategies of how you could still play on some

of these inefficiencies but we pointed out that's

extremely short term and in our conclusions at that time because

we made several presentations on the topic because it was not clearly seen

by many investors at that time and

then put together some notes and we said that basically,

the preferred shares, the way they existed were inefficient and they were

posed to disappear unless and until

some changes in the treatment of that would take place.

Some of them did indeed take place, some of them didn't.

But for us, the key story here is the contribution of the lack of

good corporate governance in the potential value in this case, destruction situation.

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