Hostile takeovers and economic efficiency

1. DEFENCES AGAINST HOSTILE TAKEOVERS

1.1. Supermajority Amendments

If shareholders believe that the risk of takeover could have adverse conse­quences for the value of the firm, they could make adjustments to their corporate constitutions. Changes in the composition of the Board of Directors or mergers would have to be approved by more than a simple majority of votes – perhaps two-thirds or more. In fact, such supermajor­ity amendments are not common. Where they have occurred, the effect on stock prices appears to have been negative.¹¹

1.2. Dual-class Recapitalisations

Stock can be issued which gives the holder a claim to the residual but only a restricted voting right. In the United States during the takeover boom of the 1980s, stock with enhanced or restricted voting rights became common enough for the New York Stock Exchange to petition the Securities and Exchange Commission to relax the requirement that each share traded on the exchange should carry one vote. Jarrell, Brickley and Netter (1988) comment that the ‘typical dual class firm is already controlled by insiders and the recapitalisation provides a means to raise needed capital for posi­tive Net Present Value projects without dilution of control’ (p. 61).

1.3. Poison Pills

Sections 2 and 3 were concerned with the free-rider problem and the result­ing tendency for takeover activity to be discouraged. Grossman and Hart suggested that a dilution of the existing shareholders’ rights might encour­age bidders. Bidders might be permitted to purchase remaining shares from shareholders on terms disadvantageous to the latter. If, on the contrary, takeover activity is considered to be too high for the reasons discussed in sections 4 to 7, it can be inhibited by ‘negative dilution’. Existing sharehold­ers, for example, can be given enhanced rights to sell their shares to the company at favourable prices following a raid. This is the essence of the so- called ‘poison pill’. The pill contains provisions which make a company extremely unattractive to a takeover raider.

It is an interesting feature of poison pills in the United States that the courts have upheld the right of managers to introduce some varieties without the consent of shareholders. This position has been justified by the ‘Business Judgement Rule’ which is designed to prevent shareholders from questioning particular business decisions in the courts. Jensen (1988) argues that this position fails to distinguish ‘decision rights’, which shareholders delegate to managers, from ‘control rights’, which they keep for themselves. ‘The Courts are effectively giving the agent the right to change the control rights unilaterally’ (p.43). In an analysis of the effects of takeover litigation in the courts, Ryngaert (1988) found that fifteen out of eighteen pro-poison- pill decisions resulted in negative effects on the stock price of the target firm. At present, therefore, it is far from clear that poison pills are being intro­duced with the consent of shareholders in the interests of protecting other stakeholders from ‘hold-up’ or as a weapon against ‘short-termism’.

1.4. Greenmail

If a potential raider accumulates a certain fraction of a firm’s stock, it may give the target management the option of repurchasing these shares at a premium in return for not pursuing the takeover. When the management of a firm makes such ‘targeted repurchases’ it is popularly said to pay ‘green­mail’. This can hardly be regarded as a long-term policy of protection against takeovers. However, the question arises of whether greenmail pay­ments are against the interests of target shareholders.

Clearly, if managers are inefficient and merely protecting their position in the firm, greenmail will deplete shareholders’ funds and the price of the stock will end at or below its pre-raid level. Greenmail, in these circumstances, is a manifestation of the moral hazard problem. Shareholders would prefer managers to declare a policy of never paying greenmail. If, on the other hand, information asymmetries had resulted in a systematic undervaluation of a good firm’s shares because a low div­idend was wrongly interpreted as a bad signal, or ‘pooling beliefs’ on the part of shareholders had left the shares below their ‘true’ level, payment of greenmail would simply result in a correction of this false impression. The informed ‘greenmailer’ would be performing a useful public service in correcting a false stock market valuation, while target managers would be serving shareholders’ interests by preventing them from accepting a low offer.¹² Here, the greenmail payment arises from the improvement in the information available and serves to mitigate the adverse selection problem.

Since the payment of greenmail uses cash, however, it might be argued that it represents a species of ‘forced signal’ and that the greenmailer’s activities therefore exacerbate short-termism. If managers of good firms do not signal, raiders will do it for them, and managers will simply find themselves having to pay greenmail. There is an important distinction, however. In the greenmail case, it is an ‘outsider’ that has initiated the signal. The existence of outsiders who see the firm as in a good state will affect the ability of managers to raise new capital.¹³ Stein’s signalling model of short-termism, discussed in section 5, was based on the assumption that no ways of convincing the capital market of the long-term state of the firm existed apart from the wasteful use of capital. Firms who found themselves in the ‘good’ state could afford to waste more capital (by distributing it) than those who found themselves in the ‘bad’ state.¹⁴ The greenmail case is different. If markets believe the greenmailer’s assessment of the worth of the firm when he/she ‘threatens’ to bid for shares at a premium, real invest­ment should not suffer when greenmail is paid because new sources of finance will be available.

1.5. Golden Parachutes

Instead of trying to resist takeover bids, a company which relies heavily on firm-specific human capital could reduce hold-up potential by establishing clear individual property rights to the returns from these assets. For top managers, the promise to make a large severance payment in the event of a successful takeover (that is, the provision of a ‘golden parachute’) can be seen as compensation for the loss of specific capital which might otherwise have been incurred by the managers. Fear of takeover should then, in theory, not discourage a manager from investing in firm-specific skills. The golden parachute removes the dependency that is otherwise associated with this type of asset. Similar protection for people at other levels in the organ­isation is difficult to contrive, however, short of adopting the quite differ­ent institutional structure of a cooperative or large partnership discussed in Chapter 10.

A golden parachute which compensates for the potential loss of firm- specific capital is one thing. A parachute which compensates for the search costs of the manager in the labour market and hence removes managerial dependency entirely would be another. The latter would encourage an entirely ‘passive’ attitude to takeovers on the part of managers. They would neither fight them nor embrace them. Some have argued that such mana­gerial neutrality towards takeovers would be advantageous. It would cer­tainly remove the conflict of interest which might otherwise be involved between shareholders and managers at the time of a takeover. The former are in line for a substantial bid premium to the share price. The latter are in line for the job market. Even where substantial commercial advantages could be expected from a takeover, managers would be expected to resist unless offered compensation. Full compensation for loss of position, however, would totally undermine the managerial incentive properties of takeovers. Only if it were possible clearly to distinguish takeovers aimed at removing inefficient managers from takeovers designed to achieve benefits of synergy from the combining of two firms’ operations, could this dilemma be resolved.

2. DO TAKEOVERS IMPROVE ECONOMIC EFFICIENCY?

2.1. The Takeover Wave of the 1980s

During the 1980s in the UK and the USA, conditions favoured a high level of corporate restructuring via takeovers, divestments, and management buy-outs (MBOs). The ‘market for corporate control’ appeared very active and led to a continuing debate about its effects. In the UK, the number of acquisitions is very variable, with sudden surges of activity. As a propor­tion of GDP, expenditure on acquisitions was one per cent or less in the mid-1950s and mid-1970s. However, in 1968, 1972 and 1988, the propor­tion rose to around five per cent or more of GDP. The USA also experi­enced a rise in expenditure on acquisitions as a proportion of national income in the 1980s. At five per cent of GNP in 1988, acquisitions were running at levels well in excess of post-war norms (though below estimates for the takeover booms of the 1890s and 1920s).¹⁵In contrast to the Anglo- American experience, the value of acquisitions in Japan remained below one per cent of GDP, even in 1988, and economies such as those of France and Germany were similarly less affected by takeovers. These differences will be taken up in section 11. For the moment, we briefly set out contrast­ing perspectives on the market in corporate control in the USA and the UK.

• Moral Hazard and the Free Cash-Flow Theory

For agency cost theorists of corporate structure, the takeover is a mecha­nism for disciplining managers and reducing problems of moral hazard. Interpretation of events is complicated, however, by the fact that takeovers can be both a weapon against inefficient managers and an instrument of managerial inefficiency. Jensen (1988) argues, for example, that the loosen­ing of restrictions on mergers in the USA, the movement towards deregu­lation in many industries (such as oil, gas, transport, broadcasting and financial services) and innovations in the financial field, all led to the neces­sity of considerable industrial restructuring. Often this would be opposed by managerial interests, especially if restructuring implied the shrinking of an organisation and the distribution of assets to shareholders. Rather than contemplate the orderly run down of activities and the distribution of surplus funds, managers were likely to engage in attempts to expand into new areas (often using the takeover as a mechanism) or to undertake imprudent investment projects.

Jensen gives as an example of the squandering of shareholders’ resources, the tendency of oil companies to use cash surpluses to engage in further exploration activities even when excess reserves were a major problem. This exploration activity resulted in falling stock prices until it became cheaper to obtain reserves by buying other petroleum companies than by actual geological search.¹⁶ Wherever managers had access to large cash reserves that could not productively be invested in established lines of activity, a potential problem existed. Broadcasters with valuable licences looking to diversify, or pharmaceutical companies with patents but uncertain about future technological developments, are other exam­ples of potentially cash-rich companies with shareholders vulnerable to managerial opportunism. Shareholders face the problem of laying claim to the firm’s resources and preventing wasteful ‘managerial’ investments from occurring. This explanation of takeover activity in the 1980s became known as the ‘free cash-flow theory of takeovers’.

2.2. The Role of the ‘Junk Bond’

A characteristic of the 1980s takeover boom was the use of the ‘high-yield non-investment grade bond’ popularly known as the ‘junk bond’. This financial instrument is simply a commercial loan with a yield reflecting the associated risks which can be traded on secondary markets. Three conse­quences of the widespread use of junk bonds in takeovers are relevant here. Firstly, the ability of quite small firms to raise large amounts of money by the issue of such bonds made firms that had previously appeared immune from takeover vulnerable to a raid financed by bonds. Secondly, successful takeovers or management buy-outs financed in this way implied a move to a higher debt-equity ratio. With managers holding a larger proportion of the equity than before, restructuring might often be seen as moving away from the manager’s certainty line towards the type of high-incentive con­tract discussed in section 4 of Chapter 8. Finally, in the absence of trust, bonds are a way of reassuring the providers of capital that cash will be dis­tributed and not invested in low-yielding projects. A high debt-equity ratio can leave bondholders vulnerable to the taking of reckless risks by equity­holding managers¹⁷ (as discussed in Chapter 4) but it leaves outside provid­ers of capital less vulnerable to the retention by managers of the firm’s resources.

Restructuring as a result of takeovers has been a matter of great public interest over recent years and subsection 9.4 considers some of the evidence. Using debt finance to take companies private through management buy-outs (often with eventual reflotation as a public company later on) has been less widely studied, though representing a significant proportion of the market in corporate control. Evidence from leveraged buy-outs in the United States during the 1980s suggested that performance improved significantly.¹⁸ Similarly, in the UK, where MBO activity grew substantially in number and value¹⁹ over the same period, Thompson, Wright and Robbie (1992) studied the returns to capital between the time of a buy-out and the following public share offering. The proportion of equity held by the management was found to be the main determinant of performance. ‘The size and robustness of the management ownership effect in our results lends support to the views of those . . . who see corporate re-structuring primarily in terms of increasing managerial motivation’ (p.414). On the other hand, they found ‘no support for the debt-bonding or free cash-flow hypotheses’ (p. 428).

2.3. Gains to Target and Bidding Companies

Studies of share price movements at the time of a takeover indicate that the main beneficiaries are the shareholders of target companies. Bid premia averaged around thirty per cent in the period 1980-85 in the USA.²⁰ In the UK, evidence presented by Morgan and Morgan (1990) suggests bid premia of a similar size: ‘In 1989 premiums averaged 29 per cent over the price ruling the day before the offer, and 37 per cent above the price a month before’ (p. 72). The shares of acquiring companies, on the other hand, reveal low or zero gains on average (around two per cent or less). Supporters of the agency costs approach to takeovers argue that the stock-price reactions reflect the capitalised value of future returns and that, even allowing for some redistributional effects, the overall impact of takeovers is to increase economic efficiency. Jensen (1988, p.23) writes that ‘The market for corpo­rate control is creating large benefits for shareholders and for the economy as a whole by loosening control over vast amounts of resources and enabling them to move more quickly to their highest-valued use.’²¹

The asymmetry in the distribution of the gains to acquirer and acquired firms is of interest in itself. Our discussion of the free-rider and the hold­out problems faced by bidders in sections 2 and 3 indicates why acquirers find it difficult to appropriate a large fraction of the gains available. There is, though, in addition a possible distortion introduced by the fact that some acquisitions are in any case ‘managerially’ motivated. The ‘free cash-flow’ approach implies that managers of cash-rich companies may tend to overbid for targets. If this is so, a further question suggests itself. Do com­panies that overbid or indulge in takeovers of which the markets disap­prove, themselves become the targets of other more successful predators? A study by Mitchell and Lehn (1990) investigates this issue. For the years 1982-86, they divided a sample of firms into those that were at some point ‘target’ firms and those that were never the ‘target’ of a raid. They then looked for differences in the stock market reaction to announced takeovers by these firms. They discovered that ‘The stock prices of targets decline sig­nificantly when they announce acquisitions… and the stock prices of non­targets increase significantly’ (p. 375). The probability of being a hostile target over the period was inversely related to the stock market reaction to a firm’s acquisitions. The authors argue that their results are supportive of the claims of Jensen and others concerning the role of takeovers as a disci­plinary device.

Many writers take a more sceptical view of the evidence than has been reported thus far. Although all are agreed that the shareholders of acquired firms gain considerably, the effect on acquiring firms is seen by some as adverse and the existence of net social gains as dubious. Scherer’s (1988) views have already been noted (see note 10). Morgan and Morgan (1990, p. 80) argue that the performance of ‘acquiring companies’ deteriorates during a two-year interval after a merger or takeover. They also cite the vol­atility of stock markets and the existence of merger ‘waves’ as evidence of irrational or ‘faddist’ influences. Hughes (1989), in a survey of the UK evi­dence, questions the use of changes in stock prices around the time of a takeover to measure efficiency gains, arguing that this amounts to little more than a declaration of faith. Similarly, Peacock and Bannock (1991) find ‘no concrete evidence that takeovers are predominantly “successful” whatever measure of “success” (managerial perceptions, profitability, rates of return on capital, shareholder wealth) is used’ (p. 62).

The reader will deduce from all this that, as usual in economics, empiri­cal evidence seems incapable of settling anything. Our primary purpose here, however, is not to embark on a discussion of public policy towards takeovers, but to prepare the ground for a brief outline of the properties of different systems of corporate governance in section 11. Much of the con­fusion in the debate about the effects of takeovers derives from a reluctance clearly to specify the alternative set of institutional arrangements which are to be compared with the status quo. The idea that those defending take­overs believe that markets are efficient whereas those who doubt the value of takeovers believe that markets are inefficient is very wide of the truth. It would be bizarre to criticise (say) Michael Jensen for overlooking the pos­sibility of inefficiency arising from information asymmetry and agency costs. Jensen, as we have seen, was a major architect of the modern agency cost theory of the firm.

Supporters of takeovers are likely to argue that moral hazard is a more significant problem than short-termism deriving from adverse selection; that, in a stock-market economy, takeovers place limits on managerial behaviour; and that to raise the costs of takeovers would lead to higher levels of managerial shirking. Note that all these propositions could be true even if no takeover was ever observed to take place or if the takeovers that did occur produced no rise in combined shareholder value. Managers might, for example, keep the costs of their shirking to levels below the transactions costs required to unseat them. Supporters of takeovers are implicitly offering a scientific prediction, which they would prefer not to see tested. ‘Increasing the costs of takeovers while leaving institutional arrangements otherwise unchanged will reduce the productivity of eco­nomic resources.’ The experiments reported in earlier paragraphs do not test this proposition.

Critics of takeovers are likely to argue that the adverse consequences of short-termism are substantial; that, in a stock-market economy, low take­over costs exacerbate this problem; and that higher takeover costs would produce social gains if the danger of moral hazard were countered by the more direct monitoring of managers. Critics are therefore implicitly offer­ing a scientific prediction that they would be prepared to see tested. ‘Increasing the costs of takeovers combined with an adjustment to the monitoring arrangements faced by managers will increase the productivity of economic resources.’ The experiments reported in the previous para­graphs do not test this proposition. Both the prediction of the supporters of takeovers and the prediction of critics of takeovers could be simultane­ously true. For completeness we should recognise that a strong opponent of takeovers might be prepared to predict a rise in productivity from their restriction, even without changes in the monitoring environment. This would produce a direct conflict in the predictions based upon different beliefs about the relative influence of the problems of adverse selection and moral hazard.

Although evidence on the effects of takeovers is difficult to gather and interpret, strong opinions are nevertheless expressed, both by way of criti­cism and support. This discussion of corporate governance derives much of its momentum from the fact that quite different systems can be observed in different countries and that this comparative experience is seen as rele­vant to the formulation public policy. A detailed appraisal of policy towards mergers and takeovers would take us beyond the scope of this book. Nevertheless, a brief outline of existing systems of corporate govern­ance will enable us to link their characteristics to some of the theoretical issues which have been discussed so far. Before embarking on this discus­sion of comparative systems, however, it will be useful to discuss the con­nection between corporate governance and financial structure.

Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.