The takeover and capital structure of the firm

1. THE ENTREPRENEUR AND THE TAKEOVER

Inherently, a joint-stock firm is neither concentrated nor dispersed in the structure of its shareholdings. No document or constitution exists pro­claiming that a particular company’s shares will be dispersed widely. The degree of concentration or dispersion is capable of changing over time. It may appear at any given moment that shareholdings are dispersed and management has great discretionary power, but financial capital can congeal suddenly and unexpectedly. A dominant interest can emerge which changes the top management and consigns the existing top managers to the labour market. As with the model of Shapiro and Stiglitz (1984), reported in Chapter 6, the penalty involved in being fired will depend on conditions in this market. If all managers were identical, the penalty might be a period of unemployment (top managers’ salaries are above market-clearing levels). Where managers differ in attributes and skills, the penalty might be extorted through downward revision of the wage, as suggested by Fama. This will occur because managers, fearing takeover themselves, will have a clear incentive to avoid appointing other managers with a poor record.

Fama (1980), however, explicitly rejects the influence of the takeover or the entrepreneur as necessary ingredients in an explanation of the opera­tion of the labour market. Manne’s (1965) description of management dis­cipline as an ‘entrepreneurial job’ is criticised (p. 295) and the takeover is considered merely a ‘discipline of last resort’. Instead, Fama prefers to rely on markets in outside directors (p. 294) who ‘are in their turn disciplined by the market for their services which prices them according to their perfor­mance as referees’. Like a steeplejack gingerly edging further and further up an elaborate tower of indeterminate height, monitor stacked upon monitor, Fama is apparently determined not to look down. The whole argument is reminiscent of debates surrounding the survival of a paper cur­rency. Once the psychology of acceptability has been established, no one bothers to present his or her paper to the issuer and demand the gold or other commodities promised. Yet many would still argue that the potential for convertibility would be important in maintaining confidence in circum­stances where coercive power cannot compel acceptance of the currency. Similarly, in a free society, the survival of the dispersed joint-stock company ultimately depends upon a recognition that it can be turned into something else. The agents of any such transformation are Kirznerian entrepreneurs.

Where the management of a dispersed corporation is judged by an outside entrepreneur to be inefficient, the advantages of establishing a con­trolling interest are obvious. The gains from closer monitoring may out­weigh the disadvantages of less-widely-spread risks and, if this is so, entrepreneurial rewards are available. To achieve these rewards, however, the entrepreneur must have knowledge which is not widely available to others. As was seen in Chapter 3, the entrepreneur will gain if his or her judgement is different from that of other people and it proves to be correct. However, where information is publicly available and capital markets are efficient in using this information for valuing assets such as equity shares, the scope for entrepreneurial action is much more limited. The difficulty is once more the free-rider problem.

2. THE TAKEOVER AND THE FREE-RIDER PROBLEM

As Grossman and Hart (1980) point out, if the public-good trap and the free-rider problem prevent internal monitoring by existing shareholders, it seems unreasonable to assume that the same problem would not be faced by outsiders. Specifically, any offer made by an outside bidder for the exist­ing shares will not succeed because it will be in no individual shareholder’s interest to accept the price and sell to the raider. Our Kirznerian raider is hoping to gain from the appreciation of the shares which s/he purchases, but any profit which s/he makes ‘represents a profit shareholders could have made if they had not tendered their shares to the raider’ (p. 43). A small shareholder will reason that whether or not they accept the raider’s offer will not perceptibly affect the chance of the raid succeeding, and they will refuse in the hope of making capital gains.² The problem is similar to that encountered in Chapter 4 by the entrepreneur attempting to purchase communal rights to fish in the island lake. An existing holder of the com­munal right might ‘hold out’³ for a price which made the whole enterprise profitless.

Differences in information and expectations between raider and share­holders may permit profits to be achieved by the entrepreneur and hence takeovers to take place. However, if the threat of takeover is to exercise a disciplinary effect on managers we might argue that efforts to circumvent the free-rider problem will be sought by shareholders to encourage entre­preneurial intervention. To overcome free riding it is necessary to exclude non-payers. How can this be achieved? Grossman and Hart suggest that minority shareholders (that is, those who do not tender their shares to a raider and still hold shares in a company following a successful raid) might be excluded from the benefits brought about by the raider. Once a raider has control of fifty-one per cent of the shares, the assets or output of the company could be sold to another company owned by the raider at a price disadvantageous to minority interests. A constitution which permitted a raider to behave in this way would represent a ‘voluntary dilution of (the shareholders’) property rights’ (p. 43) which was nevertheless ‘essential if the takeover bid mechanism is to be effective’ (p. 46). Shareholders face a trade-off. The greater the ‘dilution’ they permit, the more closely are man­agers constrained by the takeover threat, but the prospect of pecuniary gain arising out of a raid is reduced. The attitude of the law towards post-raid behaviour of the new majority shareholders, and the provisions of corpo­rate constitutions, will therefore play an important part in determining the costs of pursuing a takeover. Managers of a dispersed corporation, if they wish to avoid the managerial labour market, must therefore exert a level of effort which leaves no scope for pure profit on the part of a raider after allowing for the costs which s/he will incur.

3. MINORITY SHAREHOLDERS AND THE TAKEOVER

The Grossman and Hart paper clearly identifies an important problem, but as a description of the market in corporate control it seems to prove too much. Takeovers do take place on a substantial scale, and indeed the 1980s saw an upsurge in corporate restructuring which, if conditions reflected those assumed by Grossman and Hart, could hardly have taken place. As in sections 4 and 5 of Chapter 8, the influence of shareholders with a minority interest can prove decisive in certain circumstances.

Shleifer and Vishny (1986) present a model of takeovers in which a bidder accumulates a proportion (say five to ten per cent) of the target firm’s stock prior to announcing the bid. It is assumed that the target share­holders (each of whom, with the exception of the bidder, holds insignifi­cant amounts of stock) do not know the extent of the improvement in value that the bidder can achieve. Thus, there is an information asymmetry that allows takeovers to occur. If all the recipients of the offer have the same information about the firm, and if they are all risk neutral, they will accept any offer which equals or exceeds their expectation of the improvement in share value which will result from the takeover. Providing this expectation (which may be affected by the value of the bid) is less than or equal to the improvement actually achievable by the bidder, the latter can gain from this difference in value on his/her own stockholdings. It still remains true, of course, that ‘bidders have to share a lot of the value gains with sharehold­ers of the target firm’.⁴

Although the approach of Shleifer and Vishny succeeds in isolating and analysing some significant features of the takeover process it still results in some curiosities. Because all target shareholders have the same informa­tion, the predicted bid will equal their expectation of the value of an improvement achievable by a bidder. This implies that the actual size of the improvement achievable will not influence the bid. High improvement bidders will make the same offer as low improvement bidders. Further, observed bids will all just be sufficient to induce acceptance and therefore will not fail. These considerations led Hirshleifer and Titman (1990) to develop the Shleifer and Vishny analysis. They incorporate variation in the information about possible value improvements available to target share­holders. In these circumstances, the expected number of shares tendered to a raider will increase with the value of the bid. Risk-neutral raiders calcu­late the optimal bid which will maximise their expected return, but this bid will not absolutely guarantee success in terms of attracting a level of accep­tance sufficient to give a raider majority control. Thus, some raids will be observed to fail. Because the cost of failure will be higher for bidders who might have achieved substantial increases in share value compared with those able to make improvements of only low value, the former are expected to make a higher offer than the latter. The optimal bid rises with the improvement achievable by the bidder. Further, a bidder who begins with a higher proportion of the shares will need to attract fewer accep­tances to gain control. Thus, the probability that a bid will succeed rises with the size of the initial holding.

These features of Hirshleifer and Titman’s analysis would seem consistent with the stylised facts about the market for corporate control. The main point of the model, however, is that it relies on the existence of minority shareholders to facilitate the takeover process. Holders of substantial blocks of shares confer benefits on other shareholders and it would be expected that share values would be higher where such blocks exist than where they do not. The free-rider problem is not completely solved, but it is in the inter­ests of a minority shareholder to provide monitoring services, either directly or through the takeover mechanism, up to the point at which the marginal private benefits equal the marginal private costs.

4. HOLD-UP, BREACH OF FAITH AND THE TAKEOVER

Sections 1 to 3 have proceeded on the assumption that the takeover is a vehicle for entrepreneurship and the achievement of efficiency gains. There is another side to the takeover, however. This is the takeover as a vehicle for rent seeking, a challenge to insecurely held property rights and a cause of efficiency losses. As we noted in Chapter 6, although clear in principle, it is often difficult in practice to distinguish between rent seeking and entrepren­eurship.

In the case of hostile takeover activity, the possibility exists that the raider gains by diverting income from other sources rather than by improv­ing the efficiency of the firm and increasing total income. Shleifer and Vishny (1988) quote the case of Icahn’s takeover of Trans World Airlines. It was estimated that the present value of the loss of wages to the three labour unions involved was greater than the takeover premium paid to TWA shareholders. TWA shareholders gained while TWA workers lost. The takeover was redistributive. This does not prove that there were no net efficiency gains resulting from this particular takeover, but it does suggest the possibility that large redistributive effects may encourage rent seeking at the expense of entrepreneurial initiative.

Raiders can gain by renegotiating contracts with suppliers of various inputs (especially, but not exclusively, labour). Clearly, they can only succeed in this attempt if the resources involved are dependent on the firm as discussed in section 2.4 of Chapter 8. The causes of dependency are then crucial to an assessment of the consequences of contract renegotiation. Suppose, for example, that the labour force in this particular firm had formed a strong union, had pushed up wages above those in competing firms (thus producing dependency), and had prevented managers from hiring labour from any other source. The return to shareholders had fallen and so had the price of the firm’s shares on the stock market. Suppose that a raider now takes over the firm and breaks the union. The share price returns to the level associated with other firms in the industry. Assuming that production methods and the technical efficiency of the organisation are not affected (a somewhat unlikely situation) redistribution of income would be the exclusive consequence of the takeover. Resources invested in the actual takeover process would then logically represent social losses. The whole episode represents a fight over who receives the quasi-rents on share­holders’ capital. Absence of agreement on this issue can be socially very destructive. Labour robbed capital. Capital then retaliated. In the process, resources were wasted.

Dependency, however, can result from sources other than collective action within the firm. Where the existence of dependency implies an expression of trust in the good faith of the firm, contract renegotiation after a takeover may result in social losses far in excess of the mere resources expended in the negotiations, for such behaviour destroys trust and with it the ability to contrive beneficial and efficiency-enhancing agree­ments in the future.⁵ Willingness to invest in transaction-specific human capital, to transact with the firm by designing and supplying specialised inputs, and to accept incentive schemes based upon promises of rising future income will all be undermined if new ‘owners’ fail to honour the implicit obligations entered into by the firm in the past.

5. ADVERSE SELECTION, SHORT-TERMISM AND THE TAKEOVER

A major question remains unanswered concerning the vulnerability of spe­cific assets in the takeover process. If the ‘goodwill’ underlying these assets is so important to the long-run health of the firm, why would a takeover raider wish to destroy them? Would not such vandalism immediately be reflected in lower share prices as investors noticed how these actions were casting a blight on future prospects? At the heart of this question is the issue of the efficiency of the capital market. Clearly, if information about the behaviour of those who exercise the decision rights over the resources of a firm is publicly available, and if the implications of that behaviour can be interpreted at low cost, the prices of securities would move rapidly to reflect changes in conditions. If outside shareholders are less well informed than insiders, however, information asymmetries can radically change this perception of capital markets.

Leaving aside the possibility that valuable long-term assets might inad­vertently be destroyed, either by the blind ignorance of a takeover raider or by the cunning that hopes to profit from the ignorance of others – perhaps by raising short-term profits and selling out to people who are unaware of the long-term cost; there is still the possibility that information asymmetry could lead managers generally to act in ways that are destructive of long­term value. This possibility does not derive from the moral hazard problem. Even where managers are fully devoted to shareholders’ interests through stockholdings of their own (as in Chapter 8, section 4) short-termism may arise. The root of the problem is the existence of adverse selection.

In Chapter 6, it was seen that adverse selection could result in signalling. A signal is an action which is rational for one type of contractor but not for another. It enables separate contracts to be established for different types of contractor. An educational qualification, for example, may be a ‘signal’ if it separates labour of high from low innate ability. We also saw in Chapter 6 that signalling could be wasteful of resources. Although it might be in the private interests of the signallers, it was possible to construct cases in which, after allowing for the costs of signalling, social losses were the result. The gain to high-ability individuals of an educational signal, for example, might be partially offset by losses to those of low ability.

In the present context, the problem is that outside shareholders may not know the true internal state of a firm.⁶ Managers of ‘good-state’ firms will want somehow to convey their status to the market. This ‘true’ informa­tion will benefit shareholders through a rise in share values and we are assuming here that managers have shareholders’ interests at heart. If share­holders were unaware that the firm was in a good state, they might be pre­pared to accept a low offer from a takeover raider. It is not necessary to assume here that the raider is any better informed than the shareholder with respect to the existing misvaluation of the shares. It may be, for example, that there is a chance of a takeover occurring anyway because of real ‘synergies’ from combining the operations of two firms and that the raider will be pleasantly surprised to learn of the true situation after the takeover has been completed.

Managers cannot simply write a letter to shareholders, or prepare state­ments in the newspapers or on the Internet, declaring the health of the firm because managers of both ‘good-state’ and ‘bad-state’ firms can engage equally in these activities. Managers of ‘good-state’ firms require a signal. They may, for example, distribute a high level of dividends to shareholders. Assume that this possibility is denied to ‘bad-state’ firms and that it will convince the market that the firm paying high dividends is ‘good’. The firm’s share price will then reflect that ‘true’ information. A ‘separating equilibrium’ is established in which ‘good-state’ and ‘bad-state’ firms are distinguished by the market and gains (even inadvertent ones) to takeover raiders at the expense of shareholders no longer occur.

Although a system which permits the communication of valuable infor­mation about the true success of a firm to existing shareholders is beneficial to them, a wider perspective may reveal substantial disadvantages. In the model described above, the signal merely prevents a possible redistribution from existing shareholders to takeover raiders. The lower the costs of take­overs and the more likely they are to occur, the greater is the value to exist­ing shareholders of the informative signal from the managers. On the other hand, the signal creates no new opportunities for efficiency gains, and trans­mission of the signal was not costless. Suppose that the payment of a higher present return to shareholders means that resources are diverted from long­term investments in research and development or prevents full advantage being taken of other investment opportunities. Such managerial ‘myopia’ or ‘short-termism’ will have efficiency reducing long-term consequences.

Shareholders as a group might have been better off had they somehow bound the managers not to signal. After all, once the belief is widely held that dividends are a signal, managers operating in the shareholders’ inter­ests have no option but to engage in signalling. Absence of a signal will be taken as a bad sign and the shares will be valued on the (possibly false) basis that the company is a ‘dud’. If, on the other hand, shareholders believed that dividend decisions were not signals, the share price reaction to a low dividend would be less pronounced. Low present dividends might simply imply that resources were being used for investment rather than that a ‘bad state’ had occurred. Both good and bad firms would declare lower divi­dends (a pooling equilibrium). Although the share price of a good firm might be somewhat lower than would prevail in the context of a ‘good- news’ signal, any possible loss in the event of a takeover occurring might be more than outweighed by the eventual gains derived from the pursuit by ‘good’ firms of a long-term investment strategy.

The upshot of this type of reasoning, therefore, is that the existence of the takeover threat combined with information asymmetry can result in wasteful signalling and short-termism. If the costs of mounting a takeover are low and thus the probability of succumbing to a raid is high, managers will signal. If takeover costs are great and the probability of being taken over is very low, then signalling may reduce the return to shareholders. So- called ‘pooling beliefs’ about dividends may then be current (that is, share­holders will not necessarily view a low/high dividend as a signal of a bad/good ‘state of the world’). Where managers are assumed to value their control of the firm for its own sake, and where raiders are assumed to share the inside knowledge of managers about the true valuation of the company, the temptation on the part of managers to embrace short-termism will be greater. Under-valuation of shares on the market will be less acceptable to managers the more likely is a takeover and the more pronounced are their personal losses associated with it. The existence of informed raiders and fear of job loss both push managers in the direction of greater market sig­nalling.

6. MORAL HAZARD, MONITORING COSTS AND THE TAKEOVER

If adverse selection leads to the use of dividend payments for signalling and the possibility of short-termism, moral hazard has been seen by some theorists as producing somewhat different results. Suppose that informa­tion asymmetry prevents shareholders from monitoring and disciplining managers in the manner discussed in Section 5 of the last chapter. Suppose also that the costs of mounting a takeover are high. Providers of capital will require some assurance that the managers will not shirk or use the resources of the firm to pursue their own rather than shareholders’ inter­ests. A long-term commitment to pay a regular dividend can then be seen as a mechanism for inducing effort and assuring shareholders of a minimum return.

Economic theorists, working with the full information assumption, have in the past found it difficult to explain why firms are observed to dis­tribute assets to shareholders. Where capital markets are well developed and information costs are low, a requirement to pay a dividend would not seem necessary. Especially when the tax systems of many major countries discriminate against distributions and when profitable investment oppor­tunities are available to a firm, distributions of dividends would appear not merely unnecessary but irrational. Shareholders should logically prefer to avoid some tax on the profits of the firm and to take their income in the form of capital gains on the market value of their shares. The difficulty, of course, is that shareholders will only be prepared to accept such a policy if they have good information about managerial competence and the likely profitability of the investment opportunities available, and can always enforce distributions at low cost should they dis­agree with the managers’judgements. Where neither of these conditions exists, regular dividends can be seen as a means of building a long-run reputation.

One view is that dividend payments are a mechanism by which the man­agers commit themselves to use the capital market for new funds, thereby subjecting themselves to greater scrutiny from the providers of new capital (Easterbrook, 1984).⁷ Given the initial assumptions of high monitoring costs and plastic assets, however, it is not clear why the providers of new capital should be any better informed than the existing shareholders. De Alessi and Fishe (1987) therefore prefer to regard dividends as a way of reducing information and monitoring costs to shareholders. Regular divi­dends represent ‘a commitment of minimum performance on the part of the management’ (p. 43). Just as buyers or suppliers can commit themselves to buy or sell at declared and relatively stable ‘posted prices’ rather than take advantage of every opportunity to renegotiate more favourable terms, so joint-stock firms with widely dispersed shares commit themselves to stable dividends and promise implicitly not to ‘hold up’ the vulnerable shareholders. This interpretation of dividend payments is similar to that of Wu (1989) discussed in section 2.3 of Chapter 8.

It should be clearly understood that this explanation of dividend pay­ments does not rely on their acting as a ‘signal’. The commitment is to a regular and relatively stable payout to encourage effort. In the ‘signalling’ world of section 5, a firm going through bad times cut its dividend. It did this because it was unable to fool the market into thinking it was ‘good’ (the truly ‘good’ firms would always signal in ways that the bad ones could not match). Maintenance of the dividend in the face of adverse results would therefore serve no purpose. In this section, however, there is a purpose to maintaining the dividend rather than reducing it. A reputation for regular payments is valuable to the firm. Cutting the dividend might destroy market confidence in the firm’s ability to deliver minimum standards of perfor­mance in the long run.

The cost of mounting takeovers provides the important link between sec­tions 5 and 6. In the case of the adverse selection problem, high takeover costs discouraged signalling and permitted resources to be devoted to long­term investment. Low takeover costs led to wasteful signalling and short- termism. In the case of the moral hazard problem, high takeover costs implied that a reputation for the payment of regular dividends was neces­sary to reassure shareholders. Low costs of asserting control and enforcing distributions when managers misuse funds would make such a reputation less necessary (see section 9). Thus, short-termism can be seen as the result of both high and low costs of mounting takeovers. Low takeover costs produce dividends as signals. High takeover costs may produce dividends as a commitment to minimum performance. Either way, asymmetric infor­mation has consequences for long-term investment.

7. THE TAKEOVER AND CAPITAL MARKET EFFICIENCY

We have seen in sections 4 to 6 that takeovers may have a destructive as well as a constructive side. Some analysts have argued that they threaten firm- specific assets, and may lead to short-termism by inducing higher cash dis­tributions and lower investment than is socially desirable. How far these criticisms are justified is an empirical rather than theoretical issue. It is important, however, to distinguish between various different propositions about capital-market efficiency.

1. There is first the assertion that the capital market makes systematic mistakes in valuing assets. Even in the context of publicly available information, the market might underestimate the productivity of long- run investments in physical capital or research and development, or fail to appreciate the adverse long-run consequences of stealing the quasi­rents from firm-specific assets. Capital markets may not satisfy the requirements of fundamental-valuation efficiency to use Tobin’s (1984) terminology. Capital markets would be efficient in this sense only if the valuation of financial assets always reflected accurately ‘the future pay­ments to which the asset gives title -…if the price of the asset is based on “rational expectations” of these payments’ (p. 126).⁸
2. There is second the possibility that, in a world of asymmetric informa­tion, capital-market pressures lead managers to act myopically. The implication is that managers take actions which are disadvantageous for society as a whole even though the value of shares may reflect the rational expectations of traders in the market about the firm’s future payments to shareholders. Stock prices, that is, are rationally based on available information, but not on full

The distinction is important because a capital market that is perfectly effi­cient in valuing assets on the basis of existing publicly available informa­tion may nevertheless not produce efficient results where there are asymmetries in information availability. In general, attempts to disprove² market efficiency by showing that there exist ways of using available infor­mation systematically to make profits (that is, to ‘outsmart’ the market) have failed. Even studies of professionally managed funds have shown that they have not outperformed the market. Available information seems rapidly to become incorporated into the prices of traded shares and the possibility of using information about investment plans (for example, by buying shares in firms with high R&D expenditures, which the market, by hypothesis, undervalues) has not been confirmed.

Critics have argued, however, that studies showing a random pattern of price movements are testing a particular form of market efficiency – infor­mation arbitrage efficiency. A market may be efficient in this sense without, it is said, implying that it satisfies the requirements of fundamental- valuation efficiency. The latter implies the former. The former is necessary but not sufficient for the latter. In the extreme case, for example, all the information available to the market might be ‘wrong’ and prices would depart from the ‘correct’ efficient ones. Alternatively, the implications of correct information for the future of a firm might be ‘wrongly’ interpreted by stock market traders. In neither case would information arbitrage effi­ciency be ruled out, though prices might depart from ‘true’ fundamental valuations. The difficulty with these arguments is that objective knowledge of what constitutes ‘correct’ information or ‘rational’ interpretation of this does not exist. Any general demonstration that markets are either efficient or inefficient in terms of fundamental valuation is therefore impossible. All that can be done is to test ad hoc assertions about the nature of stock market irrationality against the evidence.

Claims that institutional investors pay exclusive attention to current div­idend flows – for example, selling shares in companies who adopt long-term policies of investment, thus depressing their share prices and making them vulnerable to takeover – fail to attract much support in the empirical litera­ture. A report by the Office of the Chief Economist of the United States’ Securities and Exchange Commission (1985) found no relationship between the size of institutional shareholdings and vulnerability to takeover, or lower R&D expenditure. Higher R&D expenditure did not appear to result in a greater risk of takeover. Indeed, announcements of R&D expenditure were associated with stock price increases. Hall (1988) looked for evidence that acquisitions cause a reduction in R&D expenditure. She found that firms involved in mergers and those not so involved could not be distin­guished on the basis of their pre- or post-merger R&D performance (p. 93). McConnell and Muscarella (1985) confirmed that higher planned capital expenditure was associated with increases in the value of common stock except in the cases of exploration and development in the oil industry (see section 9) and the regulated utilities, the profits of which are controlled.¹⁰

The fact that the capital market responds to available information in ways compatible with efficient forward-looking valuation of common stock does not, however, necessarily mean that it copes efficiently with the moral hazard and adverse selection problems associated with information asym­metry. Stock prices will not reflect ‘inside’ information and pressure from the takeover might theoretically result in managers acting in a short-termist way. Even those who are convinced of the efficient properties of capital markets with respect to publicly available information accept that signal­ling may be an important feature. Marsh (1991) writes, for example, that ‘Current dividend announcements are thus an important signal of man­agement’s own (inside) knowledge and judgements about the longer-term future of the companies they manage’ (p. 6). It was, though, precisely this incentive to signal when takeover costs are low that led to the diversion of resources away from investment towards distributions in Stein’s (1988) model of managerial short-termism outlined in section 5.

If fundamental-valuation efficiency is interpreted to require symmetric and public information, few analysts would claim that stock markets were efficient. The very fact of large trading volumes could be used as evidence against the ‘efficiency’ of the market on the grounds that it must imply that large numbers of people think existing prices are ‘wrong’ and that they have better information about future prospects, or more developed analytical skills, or superior judgement, compared with other traders. A truly ‘efficient’ market would, if we were to follow this line of argument to its logical con­clusion, be entirely ‘non-speculative’ (that is, it would be based on objec­tively correct and publicly available information). Yet a non-speculative capital market is a contradiction in terms. As we have seen elsewhere in this book, the economist’s notion of efficient markets is quite capable of wiping out the entire trading system.

Demsetz’s (1969) warning against nirvana economics must be remembered at this point. If stock markets are inefficient from a fundamental valuation point of view, so also is every other asset-price determination system yet devised. Available institutional responses to information asymmetry are the relevant comparisons to make. How they compare with a world of zero infor­mation costs is not the issue. Unfortunately, institutional comparisons are immensely complex and contentious. Three observations are pertinent here.

1. Adverse selection and moral hazard problems tend to pull in opposite directions in this field of takeovers. Restricting takeovers may reduce ‘wasteful’ signalling but is likely to increase ‘managerial’ behaviour more generally.
2. Information asymmetry is not necessarily correctly seen as a feature independent of the institutional means chosen to cope with it. For example, a system in which some major ‘inside’ shareholders were actively monitoring management behaviour would be less subject to information asymmetry problems than a system of widely dispersed ‘outside’ holdings. Of course, the former system would involve higher risk-bearing costs (see sections 10 and 11 below).
3. If takeover pressure is particularly disadvantageous to a firm (for example if it relies heavily on the accumulation of firm-specific human capital) there are various takeover defences that it can adopt. The nature of these defences is discussed in the next section.

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.