This article is written by Kashish Khattar. Kashish is a fourth-year law student at Amity Law School, Delhi. This article mainly revolves around the basic know-how of Asset Stripping.
Breaking down asset stripping into simple terms, it fundamentally refers to people (trying) to sell off parts of a company to raise money. It is typically taken in a negative sense and is almost always connected to hostile takeovers. For example, an underperforming company is bought by private equity firms. They proceed to sell off the profit-making parts of the company and close down the rest. Asset stripping is argued as something of a corporate restructuring for a company who is not making efficient use of the resources in hand. An asset stripper is a company who takes control of another firm with an intention of selling the assets of the firm, in part or whole for financial gains rather than letting the firm run as an ongoing business.
It is considered to be a problem in countries like Russia and China, where managers of a state-owned company sell the profit-making assets that they control and leave the debt of the underperforming company to the state.
Understanding asset stripping
Asset stripping was mainly an innovation of Carl Icahn, Victor Posner, and Nelson Peltz. Icahn is known for his infamous hostile takeover of Trans World Airlines in 1985, Icahn had stripped TWA of their assets by selling them piece by piece to repay the debt acquired during the alleged takeover. This raid was the starting point of an idea of selling a weak company’s assets in order to repay debt and further increase the value of the raider’s net worth.
Asset stripping was a well-known practice around 1970-80s and is still used as a strategic investment activity by private equity firms (“PE firms”). PE firms now, acquire a company, try to sell off its most liquid assets, by raiding the supposed cash coffers to pay dividends to themselves and the shareholders. For example, this supposed activity can involve taking a company private. The PE firms brand it as the recapitalization of the underperforming company.
Asset stripping can be seen as a way of cherry-picking the profit-making assets of an underperforming company and selling them to make a profit for the shareholders. These individual assets can range from different types of equipment, real estate, some kind of a goodwill for a particular brand or any kind of intellectual property. These assets are identified as more valuable than the whole company due to reasons ranging from proper management to problems related to various financial conditions of the company. The results of asset stripping are typically a dividend payment for the investors and a bankrupt company.
Asset stripping is known to be a highly controversial topic within the finance space. The good side of asset stripping only lies with the corporate raiders who can slash their debts and increase their net worth. The typical perspective relating to asset stripping is negative, with basically all the cases of asset stripping resulting in termination of employment of the whole company.
Illustration of asset stripping
Think of a company which has three different business verticals: car rental services, clothing and travel. If the company is valued at Rs. 100 crores but another company thinks that it can sell each one of the businesses, their brands, goodwill and real estate holdings to other companies for Rs. 60 crores each, an asset stripping opportunity exists. Hence, a PE firm will buy this company for Rs. 100 crores each and sell them for parts for Rs. 60 crores each potentially making a profit of Rs. 80 crores.
Asset stripping in the United Kingdom
Asset stripping per se is not an illegal practice. However, some PE firms perform some activities in the name of asset stripping which is against the law. Further, if they are found guilty by the Financial Services Authority or any other legal body. Then they are bound to face jail time or pay heavy fines. Asset stripping by PE firms in the Europe region is now regulated by the Alternative Investment Fund Managers Directive.
There are two methods by which a PE firm can go through the process of asset stripping in an illegal manner:
- Phoenixing – The target firm and the corporate raider need to have the same director so that the assets of the targeted firms can be transferred to the corporate raider without any hassle. This step is typically done to save the assets from the purview of debt. This process, in turn, allows the corporate raider to improve their individual net worth leaving all the liabilities with the targeted company. Basically, they cherry pick the assets from the firm and leave the liabilities with the old firm.
- Liquidation – The corporate raiders typically take ownership of the target company on hostile terms. Transfer their assets, and then put the undervalued target company into liquidation. This, in turn, makes sure that the raiders get what they want, improvement in their net worth and they don’t have to deal with any liabilities as the company just went into liquidation.
Who benefits from this hostile takeover?
The acquirer is attracted to the target company because of it’s most valuable assets – which can range from new technology, manufacturing base, distribution system etc. These assets can be sold for a lot of value to the right customer. The acquirer may pay more for the company by directly making an offer to the shareholders going against the will of the management. The acquirer mostly incurs debt to make their offer or pay well above the market rate for the target company’s stock. The shareholders of the target company can get a premium to the prevailing stock price. The shareholders usually see immediate benefits when their company is a target to an acquisition.
In India, the Central bank does not allow of leveraged buyouts or acquisition financing which make hostile takeovers quite difficult to execute. Furthermore, hostile takeovers do not have a good reputation wrt the political corridors and financial institutions of the country.
There have been instances, such as Swaraj Paul (UK based NRI) making a hostile bid for Escorts and DCM Shriram; Reliance Industries trying to take control of L&T; Global Tobacco trying to acquire ITC; and the infamous ABG Shipyard (&) Bharati Shipyard’s hostile bid for Great Offshore. With the SEBI takeover guidelines in place, it has become extremely expensive and difficult for hostile takeovers to succeed.
Investor protection mechanisms
The Indian market is not home to a lot of aggressive business strategies which are seen in the UK/US markets. Hence, hostile takeovers are a rare occurrence. So to answer the question about how can a company avoid a hostile takeover can be that the promoters maintain a majority shareholding (i.e. 51%) which would make the company an unattractive choice for an outsider. This is due to a lot of different reasons, the acquirer now has to take permission of the majority (the promoters) before making any substantial decisions which affect the company. Moreover, management tends to have stock option schemes in place which provide for accelerated vesting in the event of a change in control of the company. The stock options given to the management would immediately be vested one the majority shareholding changes and the employees would become shareholders of the company. The acquirer now has to buy the shares even of the employees which in turn would mean, to invest more money than before. This is quite a subtle way of making the company an unattractive choice for a takeover bid.
Asset stripping is mainly done through the process of a hostile takeover. Let us now try to understand what can be the different type of takeover defence mechanisms for the same. They can be:
- Crown jewels: The target company sells the most profitable assets or business divisions which would have attracted the acquirers in the first place. This step makes the company seem less attractive to the acquirer company for a potential acquisition. The most important thing to remember about this strategy is that the takeover regulations require that the target company should not sell their material assets without the approval of the shareholders through a special resolution and a postal ballot.
- White Knight: A white knight is quite literally the knight in the shining armour. It is the company who also makes an open offer other than acquirer company. The Board of Director then makes it clear to the shareholders that they are inclined towards the white knight’s offer. Further, this shows that management has evaluated both the offers and the offer from the hostile acquirer is inadequate and undervalues the company.
- Grey Knight: The management of the target company gets help from another corporate raider and tries to acquire the acquirer itself, which makes the acquirer busy in defending itself and takes the attention off the target company.
- Pac Man: The management instead of asking anybody else convinces the promoters of the target company to start acquiring material assets of the raider threatening to acquire the raider itself. It is known to be quite an intimidating process. However, this kind of strategy is only possible in India before the acquirer makes an open offer and announces the same in public.
- Green Mail: The target company arrange through friendly investors to accumulate large stocks of its shares which would, in turn, raise the market price. This typically makes the takeover a very expensive affair.
- Shark Repellent: The target company makes special amendments to its AoA that are only activated when a takeover attempt is announced. These amendments can range from:
(i) A special charter of bylaws;
(ii) Macaroni Defence – A firm can issue a large number of bonds with the special provisions that if the firm is being taken over, they must be redeemed at a stipulated higher price;
(iii) SuperMajority Provision – This basically requires obtaining a higher degree of votes in the general meeting to approve the change of control than what is prescribed in the regulations, which will make it difficult for the acquirer to move ahead with the takeover; and
(iv) Staggered Board of Directors – Makes it really difficult for the corporate raider to install a majority of directors on the board of the target company, thus making the management of the company a difficult process.
With the recent cases of asset stripping coming into the picture through litigation in NCLT (here) or the SEBI alleging companies for the same (here). It is a great idea to know everything about this particular strategy in India. Asset stripping is a typical strategy of various PE firms around the world. Asset stripping as defined by the Cambridge dictionary (here) is nothing but a company buying an undervalued company and selling their assets for profit. Asset stripping is widely seen in a negative sense because of the ruthlessness by which it is done. There have been cases where hostile takeovers were regarded as being beneficial for both the companies. Typically, hostile takeovers are known to destroy value and jobs. Some analysts feel that hostile takeovers have a harmful effect on the market because they are often known to fail. When an acquiring company overtakes another company, it has little to no idea about the business model, culture and the technologies that made that particular target company work. That mostly results in slow growth and consolidation which often results in layoffs.