IV Economic impact of contested takeoverstakeovers
3. The debate on the economic impact of contested takeovers in the United States
IV. Economic impact of contested takeovers
The study by Lichtenberg and Siegel is extensive and the results it indi
cates persuasive.
N evertheless, other studies have reached different conclusions. Ravenscraft and Scherer have thus m ade a study, based on a more lim ited num ber o f samples, which suggests that acquisitions have an adverse impact on productivity, see David J. Ravenscraft & F.M. Scherer, M ergers, Sell-offs, á Econom ic Efficiency p. 75 ff.
3. The debate on the economic impact of contested takeovers in the
IV. Economic impact o f contested takeovers
curity A nalysis p. 23 ff. The version dealt with in the text is the semi-strong ver
sion.
Eugene Fama20 has characterized an efficient market as a market where there are “large numbers of rational profit maximizers competing, with each trying to predict -future market values of individual securities and where important current information is almost freely available to all parti
cipants”.
The efficient market hypothesis presupposes that the market cannot “be wrong”.
If the price of a company’s stock is extraordinarily low compared to, for instance, the company’s intrinsic value, this is not caused by a “mistake”
by the market. Rather, a low stock price reflects the degree of efficiency in which a company’s assets are utilized, which, in turn, is ultimately a question of the management of the company. According to this theory, the reason for a company’s stock price to be low compared to the intrinsic value of the company is often to be found in inefficient use of the com
pany’s assets. Such inefficiency could be caused by management not being fully qualified or motivated or by lack of implementation of changes in the company’s business necessitated by new technology or a change in the market structure. The stock market values a company’s shares on the basis of the existing information about the company, including statements from management about planned projects, new investments, etc. The moment plans leading to a more efficient use of a company’s assets are publicly
¿known, the market will appreciate such information by increasing the price of the company’s stock.
For a further explanation o f the efficient market hypothesis, see Bob L. Boldt &
Hal L. Arbit, Efficient M arkets and the Professional Investor, Financial Analysts Journal, Vol. 40, No. 4, p. 22-34 (1984) and Ronald J. Gilson & Reinier H.
Kraakm an, The M echanism s o f M arket Efficiency, 70 Virginia Law Review 549 (1984). See also Eugene Fama, Random Walks in Stock M arket Prices, Financial Analysts Journal, Vol. 21, No. 5, p. 55-59 (1965).
The other well-known approach to the pricing of stock is the theory of fundamental or intrinsic value analysis. According to this theory, which has been promoted by, among others, Benjamin Graham and David Dodd as well as John Keynes, investors ought to value the shares of a company on the basis of the company’s intrinsic value, expected returns, earnings power or other standard relating to the fundamentals of that particular
20 See Eugene Fama, Random Walks in Stock M arket Prices, Financial Analysts Journal, Vol. 21, No. 5, p. 55-59 (1965).
IV. Economic impact of contested takeovers
company. The fundamentalist approach argues that investors should not, as is frequently seen, focus on comparing the shares of a company to other shares in the market.21
Keynes has compared the modem stock market with a newspaper beauty-contest where the winners are those whose choice “most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view”.22
Proponents of the fundamentalist approach challenge the assumption of the neo-classical school of thought that the stock market is “efficient”, claiming that it sometimes reacts irrationally and, for example, often fails to appreciate research and development, which may not have beneficial ef
fects for the company in the short term, but will benefit the company and its shareholders in the long run. A low valuation by the stock market of a company’s shares, according to the fundamentalist approach, does not necessarily mean that the company is badly managed or that the assets of the company are insufficiently utilized. It may very well be caused by the stock market’s lack of efficiency, understood as failure to appraise the true value of certain projects and assets of companies.23
3.2. Views in favor of contested takeovers. Proponents of contested takeovers argue that this takeover technique leads to an improved utiliza
tion of the capital invested in the stock market. Many of them assume that shares of target-companies are generally undervalued compared to the shares of other companies with similar asset-characteristics. In other words, “victims” of contested takeovers are often “limping dogs”, i.e. un- derperforming companies. Typically, they have stagnated and are charac
terized by relatively large cash-flows and large amounts of funds invested in activities or projects which do not give the shareholders as high a return on their investment as should be expected, considering the degree of risk that the shareholders are exposed to. The reason for target-companies in
21 See G raham & Dodd, Security Analysis p. 140. The views by G raham and Dodd are shared by John K eynes, see K eynes, The G eneral Theory o f Employment, Interest, and M oney p. 147 ff.
22 See K eynes, The G eneral Theory o f Employment, Interest, and M oney p. 156.
23 See F.M. Scherer, Testimony f o r the Sub-Com m ittee on Telecommunication, Consum er Protection, and Finance, House Com m ittee on Energy and C om merce, M arch 12, 1985.
IV. Economic impact o f contested takeovers
general performing below average is often to be found in management lacking the necessary skills or motivation. Inefficient management leads to inefficient use of a company’s assets.
The business rationale for an acquiror to make a contested takeover is that he expects the return on his investment in the target-company to ex
ceed the price, including the premium, he has to pay for its shares. Since acquirors will always have to pay a premium price in order to induce the target-company’s shareholders to sell their shares, contested takeovers only make sense from a business point of view if the acquiror is able to improve the performance of the target-company. In order to increase the value of the stock of this company, a more efficient use of the capital in
vested is required. This often leads to replacement of the board of directors as well as executive officers.24
In addition to increasing profitability, contested acquisitions may also lead to advantages connected to economies of scale, including an im
proved basis for developing and using advanced technology.25
Others have emphasized, in support of contested takeovers, that the threat of a takeover has a disciplining effect on corporate managements.
Management knows that the risk that the company will be taken over in
creases, the lower the market price of the company’s shares. Management also knows that an improved stock price presupposes a more efficient use of the company’s assets, which means that management is motivated to perform at its best.
An em pirical study by M ark L. M itchell and Kenneth Lehn supports this argu
ment, see M itchell & Lehn, Do B ad Bidders becom e G ood Targets? in 98 Jour
nal o f Political Economy 372 (1990).
Moreover, management is motivated by the forces of the “market for cor
porate control”.26 Management competes with other management teams for the right to manage corporations. The market, i.e. the potential future employers, evaluate the performance by management and this evaluation
24 See Thom as J. M cCord, Limiting D efensive Tactics in Tender Offers: A M odel f o r the Protection o f Shareholder Decision M aking, 21 Harvard Journal on Leg
islation 489 at 493 ff. (1984) and Easterbrook & Fischel, The Proper Role o f T arget’s M anagem ent in Responding to a Tender Offer, 94 H arvard Law Review 1161 at 1168 ff. (1981).
25 See Economic Report o f the President p. 198-199 (February 1985).
26 This theory was introduced into the literature by Henry G. M anne in the article M ergers and the M arket f o r Corporate Control, 73 Journal o f Political Econom y
110(1965).
IV. Economic impact o f contested takeovers
is crucial for the career prospects of management, thereby having a disci
plinary influence on its performance.27
The consummation of a contested takeover (the way it was done until recently) as well as a defensive management buy-out or leveraged buy
out28 lead to an increased debt and a reduced equity element in the capital structure of the target-company. For many years debt increasingly replaced equity financing. In 1987, debt amounted to approximately 85 percent of the capital structure of American companies while the figure for 1975 as well as 1980 was approximately 60 percent.29 In 1988, interest payments on debt were estimated to amount to an average of 24 percent of companies’ cash flow. However, if the debt is compared to the market value of the shares, the debt reached a peak in 1974 with 106 percent and is estimated to amount to 75 percent in 1988.30
A som ew hat different picture is drawn in a study, published in a quarterly report by the Danish Central Bank (’’D anm arks N ationalbank, K vartaloversigt” ), February 1990, p. 8 ff., in an article by Tonny Lybek and Erik H aller Pedersen.
Here a survey is m ade o f the ratio o f debt to aggregate book value of assets of non-fm ancial com panies. The survey indicates that as to A m erican com panies debt am ounted to 51 percent in 1987, 44 percent in 1980, and 45 in 1975. The corresponding figures for Danish com panies are 58 percent, 63 percent and 63 percent, respectively.
Some commentators have argued that increased debt-financing, within certain limits, benefit companies not only because debt-financing is often an inexpensive way of obtaining the necessary financing due to the right to deduct interest for tax purposes, but also because a relatively high level of
27 See M ichael C. Jensen, The Takeover Controversy: A nalysis and Evidence, in Knights, Raiders, and Targets p. 314 ff. and Ronald J. G ilson, A Structural A p proach to Corporations: The Case against D efensive Tactics in Tender Offers, 33 Stanford Law Review 819 at 841 ff. (1981).
28 See X I.9. and 10. for a discussion o f these concepts.
29 BusinessW eek N ovem ber 7, 1988, p. 140.
30 See B usinessW eek N ovem ber 7, 1988, p. 139. See also Louis Lowenstein, W hat’s W rong with Wall Street p. 148 ff. The im pact o f increased debt-financing for the research and developm ent o f a com pany is reflected in Survey o f Indus
trial Research and D evelopm ent, published on February 2, 1989, by the National Science Foundation. The study, w hich is based on lim ited em pirical evidence re
lating to the years 1986 and 1987, suggests that com panies, which have been subject to a leveraged buy-out have reduced their expenses for research and de
velopment, while other com panies have increased their research and develop
ment expenses in 1986 and 1987.
IV. Economic impact o f contested takeovers
debt compels management to manage the company in a rational way. The theory presupposes that management tends to aim at a growth of the com
pany beyond the point where such growth is in the interest of the share
holders. In management’s pursuit of maximum growth rather than a maximization of the value of the shareholders investment, the funds in
vested in the company will not be utilized in an optimal way. If a com
pany has a substantial debt, the cash-flow is reduced whereby management will have fewer funds available for use at its discretion.31 By the same token, the increased risk of bankruptcy in case the company fails to service its debt will lead to increased alertness and higher performance on the part of management.32 Subscribers to this theory state that these conclusions are supported by empirical evidence showing that shareholders of companies which incur additional debt in connection with a “friendly” or contested acquisition or restructuring receive a higher return on their investment.33
Subscribers to the view that contested takeovers are beneficial for share
holders and for society do not claim that any contested acquisition is ben
eficial. As in other kinds of corporate acquisitions (including “friendly”
acquisitions) and investments, mistakes appear. Also, there may be takeovers which lack rationality or which are abusive. However, this is not an inherent feature of contested takeovers.34 According to the theory, these few incidents do not change the general picture of contested acquisitions.
In this connection it is emphasized that e.g. liquidation of a target-com- pany and sale of its assets are not necessarily an evil, seen from society’s point of view. In such a situation the target-company’s assets will be trans
ferred to competitors or new companies in the market which will be able to use the assets in a more rational fashion, which is in the interest of so
ciety and, in addition, such a change will frequently lead to the creation of new jobs instead of those that were lost when the target-company was liquidated.
31 See e.g. the statements m ade by V ice Chairm an o f the Board o f G overnors o f the Federal Reserve System, M anuel H. Johnson, quoted in Federal Banking Law Reports, No. 1291, p. 4 (1989).
32 For these m otivating aspects o f debt, see M ichael C. Jensen, The Takeover Con
troversy: Analysis and Evidence in Knights, Raiders, and Targets p. 314 ff. at 322 ff.
33 See the studies referred to by Ronald J. Gilson, Evaluating Dual Class Common Stock: The Relevance o f Substitutes, 73 Virginia Law Review 807 at 815 ff.
(1987).
34 See Economic Report o f The President p. 191 (February 1985).
IV. Economic impact o f contested takeovers
In sum, according to this theory, contested takeovers will ensure that the capital invested in the stock market is allocated to the businesses where it is used most efficiently.35
3.3. Views that disfavor contested takeovers. Opponents of contested takeover activity have argued that target-companies are not always under
valued or underperforming.36 Some have argued that the price of a com
pany’s shares following a successful defense against a contested takeover is often higher than the price which was offered by the contested bidder and that target-shareholders thus gain when takeover bids are defeated.37 However, this argument has been challenged by many.38
Critics of contested takeovers also claim that such takeovers do not nec
essarily lead to increased efficiency. The desire on the part of many man
agements to “build empires”, i.e. create large but not always rational con
glomerates, sometimes leads to small or medium-sized rationally operated companies being taken over by less rationally managed acquirors.
Also, critics emphasize that liquidation of target-companies following a contested acquisition lead to economic losses for society, including losses as a consequence of employees being laid off, as ,well as costs in connec
tion with transfer of assets from one business to another.39 Aspects of contested takeovers which are being emphasized by proponents as advan
35 For a further discussion o f these aspects o f contested takeovers, see M ichael C.
Jensen, The Takeover Controversy: Analysis and Evidence, in Knights, Raiders, and Targets p. 314 ff.
36 For a discussion o f this view, see Louis Lowenstein, Pruning D eadw ood in H os
tile Takeovers: A Proposal fo r Legislation, 83 C olum bia Law Review 249 at 289 ff. (1983) and Edward S. H erman & Louis Lowenstein, The Efficiency Effects o f H ostile Takeovers, in Knights, Raiders, and Targets p. 211 ff.
37 See M artin Lipton, Takeover Bids in the T a rg et’s Boardroom: An Update after One Year, 36 Business Lawyer 1017 at 1025-26 (1981) and the same author in Takeover Bids in the T arget’s Boardroom , 35 Business Lawyer 101 at 106-09 (1979).
38 See the criticism by Easterbrook & Fischel, Takeover Bids, D efensive Tactics, and Shareholders' Welfare, 36 Business Law yer 1733 at 1741-43 (1981).
Thom as J. M cCord reviews the various viewpoints in his article Limiting D e
fen sive Tactics in Tender Offers: A M odel A c t f o r the Protection o f Shareholder D ecision M aking, 21 Harvard Journal on Legislation 489 at 493-496 (1984).
39 For a discussion o f som e o f these negative aspects o f contested takeovers, see Harold M. W illiams, Tender Offers and the Corporate D irectors (1979-80 Transfer Binder) Federal Securities Law Reporter (CCH) 82,445 (speech given in San Diego, January 17, 1980).
IV. Economic impact of contested takeovers
tages connected with economies of scale are by critics considered to be steps towards a monopolization of businesses.
Moreover, critics emphasize, the profits gained in connection with con
tested takeover activity does not benefit long-term investors or society but rather the arbitrageurs in the market place.40
The business o f trading on the prospect o f takeovers, mergers and reorganiza
tions that have not materialized in order to obtain a profit is known as “risk arbi
trage” . As opposed to “classic arbitrage” where one buys in one market and sells in another, the risk arbitrageurs stay in the same m arket and hope to benefit from the prem ium prices offered by acquirors, see John Brooks, The Takeover Game p. 141.
Not all commentators agree to the notion that the motivating effect of contested takeovers on management is always beneficial to the company and its shareholders. Rather than motivating management to perform well, a constant takeover threat may lead to management spending much of its time planning defensive strategies and using the corporate funds to prevent the company being taken over and management being removed. Critics of contested takeovers contend that a high level of takeover activity motivates target-management to pursue short-term results in their attempt to increase the price of the company’s shares. Management will feel tempted, in order to boost the share price, to increase and accelerate the dividend payments, thereby leaving fewer resources with the company for, for example, research and development, which benefits the company in the long run 41
Critics of contested takeovers have underscored the risk that the massive use of debt-financing exposes many American companies to a substantial risk of bankruptcy if or when a new economic recession occurs. Compa
nies which are highly leveraged, frequently by means of short-term loans, lack the necessary flexibility in case a recession comes.42 In this connec
tion the significant growth of the junk bond market has been emphasized.
While the aggregate issue of junk bonds amounted to 2 billion dollars in
40 See M artin Lipton, Takeover Bids in the T arget’s Boardroom, 35 Business Law yer 101 at 104 (1979).
41 See M artin Lipton, Corporate Governance in the Age o f Finance Corporatism, 136 U niversity o f Pennsylvania Law Review 1 at 23-25 (1987).
42 See the discussion in The New York Times, O ctober 30, 1988, Section 3, p. 1 and Louis Lowenstein, W hat’s Wrong with Wall Street p. 144 ff. For a discussion o f the use o f junk bonds, see Lowenstein, Three N ew Reasons to Fear Junk Bonds, The New York Tim es, August 24, 1986, p. D2.
IV. Economic impact of contested takeovers
1978, the figure for 1987 was 31 billion dollars. The total amount out
standing of junk bonds was 9 billion dollars by mid-1977 and approxi
mately 180 billion dollars by the end of 1988.43 Critics of this develop
ment argue that it has led to investors losing confidence in the stock mar
ket with the consequence that future investments in the market will be re
duced.44
For a long time nothing suggested that the investors had lost interest in investing in the stock market, or in junk bonds for that matter. Not even the dramatic decline in stock prices in October 1987 seemed to have dis
couraged the investors.45 As regards junk bonds, it is notable that the largest debt-financed acquisitions have taken place after October 1987.
However, a new market decline occurred on October 13, 1989, and was followed by a reaction by the market against the use of junk bond financ
ing.
In late 1989 a proposed acquisition o f U nited A irlines (through acquisition o f its holding com pany) failed due to the banks pulling back from financing the trans
action, see II. 1. This event and events that follow ed signal that financiers are getting increasingly worried about the risks involved in leveraged acquisitions.
Another aspect of debt-financing, which has been emphasized by some commentators, is the impact which a company’s junk bond issue may have on existing, outstanding debt securities 46 If the debt securities issued by a company do not contain covenants that protect the security holders against an increase of the company’s leverage, the value of the debt securities may drop significantly upon the completion of a leveraged buy-out.
In practice, most bonds contain covenants that lim it the debtor com pany’s right to issue additional debt pari passu with or senior to the existing bonds. However, such covenants often do not prevent or inhibit the issue o f debt securities junior 43 See the inform ation provided by A ssistant C om ptroller General, General A c
counting Office, Richard Vogel, referred to in B N A ’s banking report, M arch 6, 1989, p. 575.
44 See Stem gold, D eep-Pocketed D ealm akers, The New York Times, April 14, 1987, p. D1 and Rohatyn, Junk Bonds and O ther Securities Swill, W all Street Journal, April 18, 1985, p. 30 and Lipton, T akeover Abuses M ortgage the Future, W all Street Journal, April 5, 1985 p. 16.
45 For an analysis o f the developm ent as regards leverage in 1987 and 1988, see Ben S. Bem anke, John Y. Campbell & Tony M. W hited, U.S. Corporate L ever
age: D evelopm ents in 1987 and 1988, Brookings Papers on Economic Activity 1/1990, p. 255 ff.
46 See The Econom ist, O ctober 29 – N ovem ber 4, 1988, p. 81 f. and The New York Times, October 26, 1988, p. D l.