Optimal Toeholds in Takeover Contests

Abstract

In this paper we offer an explanation for the empirical anomaly that most raiders do not acquire the maximum possible toehold prior to announcing a takeover bid. By endogenously modeling the target value following an unsuccessful takeover we demonstrate that a raider may optimally choose to acquire a small toehold even if the toehold acquisition does not drive up the pre-tender offer target price. This occurs because although a large toehold increases profits if the takeover succeeds it also conveys a higher level of managerial entrenchment, and hence a lower firm value, if the takeover fails. In the paper we derive new predictions regarding how the optimal toehold and how target firm value following a failed takeover vary in the cross section. Extending the basic model we examine the impact of the presence of a rival bidder and of dilution on the initial bidder's toehold strategy.