Ch. 3: Auctions in Corporate Finance 113
about 2%.Betton, Eckbo and Thorburn (2005)argue that since toeholds are likely to
deter competition, the target might turn hostile if the bidder acquires toeholds when pri-
vate negotiations might be going on. Thus, it is unclear to what extent toeholds are used
strategically in bidding contexts. It is worth recalling in this context, however,Shleifer
and Vishny’s (1986)analysis of the role of large shareholders in the target firm: even
when they are not bidders, the presence of large shareholders in the target firm who are
willing to split the gains on their shares with a bidder has the same effect as the bidder
having an initial stake in the target.
Another approach to reconciling the existing findings on loss of value to acquirers, the
gains to targets, and joint value losses is presented byJovanovic and Braguinsky (2004),
even though their model is not explicitly auction-based. The model incorporates uncer-
tainty over the skill of corporate managers, the value of projects that companies have,
and the takeover market. In equilibrium, the takeover market facilitates the exchange
of “good” projects from firms with “bad” managers to firms with “good” managers but
“bad” projects. Ex-ante values of firms represent investors’ knowledge of management
type but uncertainty over project type. If a firm puts itself up for sale, which it does only
if its project is good and its management is bad, then investors learn that the firm does
have the property right to a good project and its value increases—hence the positive re-
turn to targets. A firm becomes an acquirer only if its own project is bad. Upon learning
that a firm will be an acquirer, investors learn that the firm’s own project is bad—hence
the negative return to acquirers. For reasonable parameter values, including a cost in-
curred in the takeover process, joint values of the target and acquirer fall. Even so, the
mergers in the model are welfare-enhancing.
4.2.2. The auction process in the market for corporate control
As our previous discussion shows, takeover models help understand some of the ob-
served empirical evidence on bidder and target returns. Another major role of auction
theory, in so far as it facilitates our understanding of the takeover bidding process, has
been to “inform” a company’s board or regulators about the impact of selling processes
or rules on shareholder wealth, efficiency and welfare. However, here, for the prescrip-
tions to be useful, the auction models must at least reasonably mimic the takeover
bidding environment. The question we address now is the extent to which this is the
case.
First, it is important to note that auction theory has developed in the spirit of mech-
anism design, or the design of optimal selling schemes. Any auction model assumes
a degree of commitment power on the part of the seller. There are clear “rules of the
game” that the seller and the bidders are required to abide by. For example, in a first-
price auction, in which bidders shade their bids, the losing bidders might want to submit
a bid higher than the winning bid after the latter is disclosed. The seller must be able
to commit not to entertain such bids. A similar argument applies to the reserve price.
Casual observation, however, suggests that many bids (even when they are friendly) are
not seller initiated. It might appear that many control contests are not really formal auc-