A takeover is essentially a hostile acquisition. It's where the buying company is trying to take over a company that doesn't want to be taken over. So just a little recap, acquired companies shares, they usually tend to increase about 30 to 40%. Upon the announcement that a takeover is happening, but the acquiring firm shares they could go up or down either way, we find that cached finance takeovers tend to increase the share price of acquiring companies. However, stock finance takeovers, those tend to decrease the share price of the acquiring company. CEOs often say that they are doing takeovers to leverage a high price earnings ratio by buying a weaker price earning company and hoping that they can apply their own price earning to the company being acquired.
But really what you're just doing is diluting out those financial state They'll just balance out between a dying industry sometimes tries to buy a hot tech company with the hope of jumping into a new industry. These usually flop. And the reason is probably because there's not much expertise going in, they just bought a company trying to be popular. It might make sense to give money to a tech firm, before efficient markets existed, because that was might have been the only way the tech firm would get money. But if an efficient market exists, then there's really no reason for this. Another reason is a CEO may try to buy hot tech company just trying to hold on to the acquiring company for a while to skies, any kind of misstating in their financial statements.
They just want to hide it the company's going down and to make it look good, they keep buying other companies. How However, some takeovers are good in the sense that if you You take over and you trim the fat to remove the lousy middle managers that aren't necessary, that can be good. Let's talk about leveraged buyouts. This is a way of raising funds to do an acquisition if you don't have the funds already, or you just don't want to spend your own money. To understand how to do a leveraged buyout, you need to understand a little bit about how junk bonds work. There is something called an investment grade bond.
This is according to Standard and Poor's a triple B rating or higher or according to Moody's, a BA rating or higher, and prior to 1977. If your bond was below investment grade, then these agencies they wouldn't let you issue a bond. Then, in 1977, Lehman Brothers made some exciting news when they issued a bond that was below triple B rating. A man named Michael Milken came around and he knows That a stock is theoretically riskier than even the worst bond. He also noted that there's often a big tax advantage to using debt. He took a job at a company called Drexel Burnham Lambert.
And he wrote a condition into his job description that he wants us to have the right to issue junk bonds once a week. With that condition, I will work for you. He then collected a commission on each of his sales. And this turns out to be a really good idea because 1985 junk bonds took off and they ended up making up about 20% of all bonds in the market. Michael Milken and Drexel Burnham Lambert became super rich. Michael Wilson, he realized later that he could use junk bonds to do a hostile takeover of a firm.
So here's the process that milken use when he was doing a leveraged buyout a hostile takeover. First of all, someone would come in wanting to do a takeover and asking milcom for help. So then the company Drexel would approach a junk bond buyer about trying to convince them to buy junk bonds out of a shell company that the bidder sets up to do takeover. So essentially, they make a company with no assets. That's what a shell company is. And this company's made with this specific purpose of doing this junk bond transaction.
The company Drexel then gets a commitment from interested junk bond buyers, and pays them a commitment fee of 0.5 to 1% of the amount that they agreed to buy and they make the shell company Drexel then gives the bidder a letter guaranteeing financing if the bid is successful. Drexel loans, the bitter shell company, the financing to do the takeover, and then after the takeover, everyone gets paid back And this might sound a little bit confusing for you. So I'm going to sum this up as this. You can use the future junk bonds of a company that you are taking over to finance the takeover itself. You can essentially takeover a company with the promise that you're going to issue bonds. And using that promise is what you use to raise the funds to do the takeover.
So where have these leveraged buyouts been done historically? If you ever watch the movie Wall Street, you'll hear of this character called Gordon Gekko. And essentially what he was doing was leveraged buyouts. The politician Mitt Romney, he was a candidate at the time competing against Barack Obama in the election, and for presidency, and how he obtained his fortune was by doing leveraged buyouts, Man name Kohlberg Kravis Roberts Roberts, who did leveraged buyouts. And these were often extremely highly leveraged up to 97% leveraged. And what he would do is he would buy out a company, fire all the old managers and bring in new management.
Private equity firms, they often do leveraged buyouts as well as hedge funds. Sometimes they do something called a management buyout. And this is where you have a leveraged buyout, but you don't replace the management. In fact, the management goes to a private equity firm and get them to do the buyout of their company. So they're trying to get someone else to buy them out. In fact, 10% of businesses selling off their assets tend to be management buyouts.
So when a company is bought, often what happens is it's broken up into lots of pieces and then the management of If one of these pieces will go and try to do a management buyout to get one of the pieces back so they can keep their jobs. What are the benefits of doing a leveraged buyout? Well, often the companies that are bought out are usually quite productive afterwards, if drastic changes were made to improve the efficiency, that's the reason it was taken over. One of the cons of a leveraged buyout is that often these are extremely highly leveraged. So there's a high risk of bankruptcy. And sometimes this doesn't appear until a recession comes a few years later.
A leveraged buyout might have 90% plus leverage. In fact, only banks often have ratios of leverage is high. And banks are different because the government will usually bank them out, bail them out if something goes wrong. Since a government will bail a bank out is usually the incentive actually for banks to get as close to 100% leverage as they can, because there's a tax benefit. But usually there's a minimum amount of bank reserves and a mandated by government. So, takeovers can be good if they are done with the purpose of trying to improve the company by trimming the fat removing the lousy middle managers who aren't necessary.
But often when a takeover is done a hostile takeover like this, the defending company the company is being acquired doesn't want to be taken over. And there's a number of defenses that they can do to prevent their company from being taken over. There's the poison pill. This is known as the shareholders rights plan. It's where the company that's being acquired they issue call options that are non transferable and out of the money. And in the fine print, it says that the call options will become in the money if the company is acquired.
So essentially the call option changes the strike price if the company is quired This is called flipping in the poison pill. And so the shares of the company become extremely diluted and whoever was trying to buy out that company, they'll suddenly find themselves owning only a small percent of the company. There's also something called a poison put. This allows bondholders to put on bonds that the company has. So the idea is that if the company is being taken over, bondholders have the right to sell the bonds back at a redemption value, usually above the sold price, the par value. So this means that the acquirer will need to prepare to find it refinance the target's debt right after the takeover.
And so there's an increased need for cash and this can raise the costs that it takes to do the acquisition. There is the defense tactic of a staggered board of directors and is where they have some kind of clause in their constitution that the company directors can only be replaced so many each year. So it might take two years before you can actually get a majority of your people on to the board to control the company, you might have all the shares, but you don't have board members, so you're still not in control. Another way could be to have a restricted voting rights where a member on the board might only be allowed to have 15 to 20% of the voting rights, even if they own more shares. So that can be a limit as well. You might have something like a super majority voting where you have to have a really, really high voting percent in order to do a takeover to accept it.
And that can be extremely difficult to get and it might be like 80% or higher. And that's might be very, very unlikely. You could have something called a litigation defense. And the idea is that if you are trying to defend yourself, you might go to the government complain that the rating company is forming a monopoly. And what this is going to do is, is the government will then trigger a whole bunch of legislation, and the government will do a bunch of investigations and this will dry out over many months and make it extremely inconvenient to continue with the takeover. There's a defense called the white knight defense.
It's where you get a friendly company, someone you're an ally with to buy up all the shares in your company. And that way, well, the takeover company can't buy because someone else has already bought it. This is often quite expensive. So more often you'll see something called a white Squire defense. It's where you get a friendly allied company, not to buy up your whole company, but just a large chunk of shares. There is a defense called the patriotism defense.
It's where you complain to the government that some kind of foreigners are coming in and taking over a company that is essential to a nation. And so these foreigners are no good. They're not good for our country. And usually This results in the target firm, their share price falling. There's a defense called the green male defense. And what you can do is you can buy back the rating company's stock with a premium.
So essentially, they buy stock trying to get your company and you just buy that stock back from them. Now, this might work short term, but usually it's going to encourage other people to try and come and use the same tactic. There is a defense called the Pac Man defense where they were trying to take over you and in response to you take over them. There is a defense called the crown jewel defense where you sell off any value Will asset that the company trying to take over you might want, so anything that might be useful to them? Well, you might engage in something like 20 year contracts with suppliers and customers to make your company unprofitable. Historically, when Napoleon had his army trying to invade Russia, what Russia did is they burned all of their towns and food and Napoleon's army essentially starved out until they had to retreat.
This is essentially the same concept. There's that offense called the golden parachute defense. And this is only for a few members in the company such as the CEO or select members of the board. And what happens is, as the board gets taken over, the CEO will get the board to fire him with a massive payout. Millions and millions of dollars of bonus in the US there was a movement against this and at the moment, anything above three times The salary of the CEO at the time is now taxed at 20% extra. So this is often a good incentive for the CEO to leave.
And usually when this happens, there's news of a golden parachute that reaches the public and stock price rises. So based on that, presumably shareholders are glad the CEO is gone. And of course, there's also the tactic where you could just buy back your own shares. So a takeover companies trying to buy your shares, you might just buy some shares of your own to make it difficult for them to get the majority that they need. You can also do a leveraged takeover of your own company. So remember leveraged takeover, essentially selling a bunch of bonds to raise funds to take over the company.
Well, you could do that yourself. And that way you can buy up your own shares. So to sum up, If you're trying to take over a company, there's a few ways you could just buy out their shares using cash or trading in shares of your own. But there's also a tactic called a leveraged buyout that you can do, where you're raising funds by essentially selling bonds of the company you're taking over. If you are a company that's being taken over, and you don't want this there are a number of different tactics that you can use to defend yourself to prevent your company from being taken over