What is a Toehold purchase?

Mergers and acquisitions are currently trending in the financial markets. Global mergers and acquisitions hit a fresh high. More than sixty thousand deals were announced in 2021, an unprecedented 24% increase. Furthermore, publicly disclosed deal values exceeded USD 5.1 trillion.

Various strategies are executed to conduct a merger or acquisition. Toehold purchase is one such strategy that is used for acquisition.

Toehold purchase

Typically, a toehold purchase is a precursor to acquisition and is common practice in global markets. Toehold purchase involves accumulating less than 5% of a company’s outstanding shares. A toehold purchase is not an ad-hoc purchase, but made with a predetermined goal. The objective of a toehold purchase may be a subsequent acquisition through a takeover bid or tender offer.

Alternatively, an investor may make a toehold purchase to exert pressure on the target company to raise its performance and improve returns.

Understanding Toe Hold Purchase

A toehold involves acquiring a small but significant equity position in a company. It establishes the interest of the company in the target corporation. Sometimes, a toehold purchase is also acquired to generate a steady cash flow of revenue in the form of interest and dividends.

Corporate raiders also use a low-profile toehold purchase to gain control over a company. If the number of shares purchased crosses the threshold, then the acquiring company is obligated to report the purchase to the market regulator and the target company.

Then, the target company has the opportunity to determine whether the takeover is desirable or not. It may also take steps to prevent the takeover if that is the most suitable course of action.

The purpose of a toehold purchase may be as follows:

1. Acquiring the target firm

   More often than not, a toehold purchase is executed to acquire the target firm. Once a toehold purchase is made, the investor may start purchasing additional outstanding shares of the company. The quantity of shares purchased subsequently tends to be less and goes unnoticed. Even if it is noticed, it is viewed as non-threatening. The objective is to purchase shares as quietly as possible.

2. Specific Objectives

   A toehold purchase may also be made to achieve specific objectives such as boosting the market value of the firm, shaking up operations, and improving the return on investment. Essentially, a toehold purchase is used to exert pressure on the management and influence its decisions. The objective is to push the management of the company to make decisions that will favour the shareholders.

Thus, a toehold purchase forces the investor’s foot (or toe) in the door of the company. Hence, the name ‘toehold purchase’.

Instances of a Toehold Purchase

In 2016, Paul Singer, a famous activist investor, disclosed a 4% holding in Cognizant Technology Solutions coupled with his ideas for increasing profitability and returns for investors. He also asserted a change in the board of directors. The results were swift and positive for not only the company but also its investors.

How Does a Toehold Purchase Work?

The Securities and Exchange Commission (SEC) is a market regulator in the United States. According to the regulations set forth by the SEC, an acquirer can purchase up to 5% equity in a target company without furnishing any information.

However, if the purchase crosses 5% of the outstanding shares, then the acquirer is required to file specified notices with the SEC. The notice to SEC must include whether additional shares will be purchased, the number of additional shares, and the purpose for the same. The notice filing also informs the public of what the acquirer intends to do with the toehold purchase and would reveal a potential takeover attempt.

Toehold Mergers and Acquisition

A toehold purchase is a tactic commonly used for the acquisition of a public company. It is especially useful in cases of a hostile takeover. A toehold purchase allows the acquiring company to begin the purchase of shares quietly, without being detected by its management. The acquiring company remains unnoticed for as long as possible and prepares itself to take control of the target company.

On completion of the toehold purchase, the acquiring company announces to the public its intention to take over the target company. The announcement is made through a tender offer. The acquiring company offers to buy the outstanding shares of the target company. Generally, the offer price for the purchase is a price above the market price of the security.

The acquiring company can also bypass the need to get approvals from the Board of Directors of the target company and make a direct offer to the shareholders who can be persuaded to accept the proposal by offering a premium on the share price. The acquiring company requires approval from the majority shareholders for this approach to be successful.

Bottom Line

While uncommon in India, toehold purchases are a common practice in the western world. In hostile or low-profile toehold purchases, investors tend to benefit since the shares are acquired at a premium. However, a takeover is not always beneficial for the company or its investors. Hence, investors must employ utmost vigilance in decision-making.