Bridge over ocean
1 September 2016 CFA Institute Journal Review

The White Squire Defense: Evidence from Private Investments in Public Equity (Digest Summary)

  1. Jonathan Wheeler Hubbard

Firms that are under takeover pressure can engage in a “white squire defense” by which they transfer stock to friendly investors under favorable terms. Although this defense is traditionally executed through an employee stock ownership program, the authors explore whether private investment in public equity can serve as an effective white squire defense.

What’s Inside?

A “white squire” operates as an ally in a possible firm takeover by buying a large block of shares. The authors consider how private investments in public equity could be a possible white squire defense. They analyze two approaches to avoid a takeover: an employee stock ownership program (ESOP) and the issuance of private investment in public equity (PIPE). Although ESOPs have been shown to provide protection over takeover bids, there has been little analysis on the effectiveness of PIPE issuances as a white squire defense. The authors’ conclusions suggest that PIPE issuance can be an effective white squire defense and is the preferred approach for firms that exhibit low earnings and high leverage.

How Is This Research Useful to Practitioners?

Firms that are under takeover pressure can initiate a PIPE issuance through which they transfer a meaningful amount of stock to investors under favorable terms, such as a price discount, generous dividends, or a board seat. Prior research suggests that about 16% of the outstanding shares are issued and that price discounts average around 13%. In exchange, investors agree to support firm management and do not seek to gain full control. Stock is issued to friendly investors—firm workers in the case of an ESOP and strategic alliance investors in the case of a PIPE issuance. As staggered boards and “poison pill” tactics have decreased in popularity, PIPE issuances may serve as a viable takeover defense.

The authors find that firms with a high relative probability of a takeover reduce that probability of takeover after a PIPE issuance. They also find that there is a relationship between firm characteristics and the type of takeover defense a firm is likely to use. Firms with poor performance and high leverage prefer PIPE issuances over ESOPs, probably because of the negative impact that ESOPs have on earnings. The results of the research also indicate that PIPE issuers are more likely to offer favorable terms to investors in an environment where takeover pressures are high.

Firms that issue private investment in public equity tend to exhibit poor stock returns and operating performance post issuance. This evidence supports the hypothesis of managerial entrenchment, in which the PIPE issuance serves to cement current management rather than necessarily compensate investors. Although prior studies have suggested that PIPE issuance may reduce agency problems, the authors conclude that PIPE issuance actually increases them.

How Did the Authors Conduct This Research?

The authors outline several hypotheses related to takeover probabilities, PIPE issuance, white squire investors, and firm performance. They test these hypotheses using regression analysis and estimate a recursive bivariate probit model to control for any simultaneity bias related to PIPE issuance and takeover activity.

The final sample of private equity placements is detailed information on 1,634 PIPE issuances from NYSE, AMEX, and NASDAQ companies from January 1995 to December 2010. These data were organized through Sagient Research’s PlacementTracker database and augmented by CRSP and Compustat files. Each sample PIPE issuer is assigned an ex ante takeover probability by estimating a probit model adjusted for heteroskedasticity. The universe contains firms listed on NYSE, AMEX, and NASDAQ from 1994 to 2010. Utilities and financial services companies are eliminated from the study. Information on takeover bids is sourced from the SDC Platinum Mergers and Acquisitions database. The authors observe that most of the PIPE issuers are small companies with brief available operating histories (a mean of 6.34 years) and low total assets (a mean of $63.65 million).

The authors’ research contributes to the existing literature through a more detailed analysis of PIPE issuance and compares and contrasts this approach with the adoption of an ESOP. They also explore the compensation mechanisms, or lack thereof, and incentives surrounding both ESOPs and PIPE issuances.

Abstractor’s Viewpoint

PIPE issuances appear to be effective as a white squire defense by reducing the probability of a takeover, which is an important conclusion. In a high-pressure takeover environment, firms that issue private investment in public equity tend to have poor operating performance, which is another important conclusion that supports the managerial entrenchment theory.

It is worth noting that the sample excludes financial services and utilities companies and that the PIPE issuers tend to be smaller, younger companies with minimal analyst following. It may be prudent to take care in the application of the study’s conclusions to an out-of-sample dataset in which the constituents exhibit meaningfully different characteristics from those in the sample.

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