Auctions of companies

ROBERT G. HANSEN [*] Auctions of companies are conducted in ways that contradict received auction theory The major puzzles are: (1) sellers restrict the number of bidders; (2) sellers restrict the number of bidders; (3) bidders are screened by an initial round of nonbinding bids; and (4) bidders offer--and sellers sometimes accept--preemptive bids. Puzzles (1), (2), and (4) are explained by assuming that some information concerning the company can, if released, reduce the value of the company. Puzzle (3) is explained as a way for sellers to select the highest-valued bidders; equilibrium is maintained by using the initial bids to set a reserve price for the final bidding round. (JEL D44, D82, G34) I. INTRODUCTION From 1989 to 1998, 19,593 private companies were reported to be bought and sold in the United States, many through an auction process. The total value of these transactions was in excess of $315 billion. [1] In addition, from 1989 to 1998, there were 13,134 reported divestitures of divisions, subsidiaries, or product lines; the value of these transactions was in excess of $900 billion. Perhaps not surprisingly, an industry of advisors/auctioneers exists to facilitate these transactions, and the institutional framework by which auctions of companies are conducted has become somewhat standardized. The purpose of this article is to apply auction theory to explain this standardized institutional framework. The article proceeds as follows: section II describes the standardized process used for selling private companies or divisions of public companies; points out how these practices conflict with certain aspects of received auction theory; and presents initial arguments that explain the rationality of the practic es. In section III, a more formal model is developed to show how some of the standard corporate auction practices can be explained. Section IV deals with what may be the most intriguing institutional practice--the use of preliminary, nonbinding indications of interest. Section V concludes the article with a preliminary discussion of entry fees and preemptive bidding. II. THE "TYPICAL" AUCTION PROCESS AND CONSISTENCY WITH AUCTION THEORY The typical process for selling a private company or division of a public company runs as follows. [2] Upon making the decision to sell, the selling company will retain (or will already have retained) an advisor who will serve as de facto auctioneer. The auctioneer, drawing on knowledge of the selling company, will draw up a preliminary list of potential bidders; this list will probably include competitors, suppliers, customers, and acquisition-oriented conglomerates or leveraged buyout houses. The advisor will also exercise his judgment at this time as to whether or not a prospective bidder will be willing and able to complete a transaction at a "satisfactory" price. If a negative judgment is made, that potential bidder will likely be excluded from further participation. The remaining prospective bidders will receive a very cursory description of the selling company and will be offered a more in-depth offering memorandum if they sign a confidentiality agreement. Although the first cursory description may no t even include the selling company's name, the offering memorandum will be quite detailed, including the sort of information that would typically be in a public corporation's Securities and Exchange Commission 10K filing as well as traditionally confidential information on current issues at the selling company, overview of costs, plans for market and product developments, and so on. The next step is for the prospective bidders to submit preliminary, nonbinding "indications of interest" for the selling company. These indications will be either a number or a range of numbers that are supposed to represent "bidders' first approximations of their estimates of the value of the target." [3] The preliminary indications are then used by the auctioneer to further reduce the number of bidders who will proceed further: "Only the top bidders on their list are permitted to go forward" [4] Although the screening is clearly not as straightforward as the preceding passage presumes, there is no doubt that the likelihood of ad mittance to the next round increases with the preliminary bid--even though that bid is nonbinding. …