S. Abraham Ravid
Yeshiva University – Syms School of Business
Matthew I. Spiegel
Yale University – Yale School of Management, International Center for Finance
Yale ICF Working Paper No. 99-05; New York University, Center for Law and Business, Working Paper No. 98-024
Prior to the announcement of a tender offer, the bidding firm is legally allowed to acquire shares in the open market, subject to some limitations. These pre-announcement purchases are known as toeholds. This paper presents a simple model that describes the bidder’s optimal toehold acquisition strategy, within an environment that closely parallels the present legal institutions. The model shows that toeholds and bids interact in a complex manner even without the presence of asymmetric information. By examining a simple environment the paper provides a useful alternative hypothesis for tests of other, presumably more complex, models. One of the main implications of our model is that if no competing bidders are expected, no toeholds should be purchased. Indeed, under a wide variety of conditions small toeholds are optimal. The paper also demonstrates that the correct specification of an empirical model can be critical. For example, under some parameter values toehold purchases may exhibit a negative cross-sectional correlation with the pre-announcement run up in the stock price. This occurs even thought prices are strictly increasing the size of the toehold. Several implications concerning various aspects of merger legislation are considered. For example, we demonstrate that a rule similar to a «fair price» provision has the desirable property that a second bidder arrives and wins if and only if he places a higher value on the target that the initial bidder.