Leverage and Corporate Performance: Evidence from Unsuccessful Takeovers

This paper finds that, on average, targets that terminate takeover offers significantly increase their leverage ratios. Targets that increase their leverage ratios the most reduce capital expenditures, sell assets, reduce employment, increase focus, and realize cash flows and share prices that outperform their benchmarks in the five years following the failed takeover. Our evidence suggests that leverage-increasing targets act in the interests of shareholders when they terminate takeover offers and that higher leverage helps firms remain independent not because it entrenches managers, but because it commits managers to making the improvements that would be made by potential raiders.     

ANTITAKEOVER CHARTER AMENDMENTS: EFFECTS ON CORPORATE DECISIONS

In recent years many shareholders have voted to amend their corporate charters to decrease the likelihood of a hostile takeover. Critics of antitakeover amendments argue that by sheltering management from the market for corporate control, management may become entrenched and be less likely to act in the best interest of shareholders. The counter argument holds that the threat of a hostile takeover and possible job loss may move management toward “short-sighted” decision making. In this study we test the hypothesis that, upon passage of antitakover amendments, managers adopt a longer-term view with respect to capital expenditures and research and development. Empirical results support the hypothesis, as both capital expenditures and research development display significant increases relative to the year of enactment.     

Managerial conservatism, project choice, and debt

We show that the incentive for managers to build their reputationsdistorts firms' investment policies in favor of relatively safeprojects, thereby aligning managers' interests with those ofbondholders, even though managers are hired and fired by shareholders.Tbis effect opposes the familiar agency problem of risky debtthat is imperfectly covenant-protected, wherein shareholdersare tempted to favor excessively risk projects in order to expropriatebondholders. Consequently, when managerial concern for reputationresults in conservatism, it can actually make shareholders betteroff ex ante by allowing the firm to issue more debt. We examinehow the optimal choice of leverage from the shareholders' standpointis influenced by takeover activity, and how the adoption ofantitakeover measures affects a firm's investment policy andleverage choice.     

Optimal toeholds in takeover contests

We offer an explanation for why raiders do not acquire the maximum possible toehold prior to announcing a takeover bid. By endogenously modeling the target firm's value following an unsuccessful takeover we demonstrate that a raider may optimally acquire a small toehold even if the acquisition does not drive up the pre-tender target price. This occurs because although a larger 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. We derive new predictions regarding the optimal toehold and target value following a failed takeover. We also examine the impact of a rival bidder and dilution.     

Have changing takeover defense rules and strategies entrenched management and damaged shareholders? The case of defeated takeover bids

Using the Delaware Supreme Court's Time-Warner decision of July 1989 as a focal point, we study defeated takeover bids before and after July 1989 to assess the direct effects of stronger takeover impediments on takeover defense tactics used to defeat bids and the resulting shareholder wealth outcomes and managerial turnover. We find that firms that defeated takeover bids after July 1989 shifted away from the use of active takeover defenses (repurchases, special dividends, greenmail, and leverage increases). Nevertheless, shareholders of firms that defeat a takeover experienced slightly better wealth outcomes in the 1990s than in the 1980s. We also find increased managerial turnover rates after defeating a takeover bid post Time-Warner, suggesting that managers that defeat hostile takeover bids did not become more entrenched due to greater takeover impediments relative to prior years.     

The Leverage Ratchet Effect

Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if the new debt is junior and would reduce firm value. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history‐dependent. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.     

Takeover Defenses of IPO Firms

Many firms deploy takeover defenses when they go public. IPO managers tend to deploy defenses when their compensation is high, shareholdings are small, and oversight from nonmanagerial shareholders is weak. The presence of a defense is negatively related to subsequent acquisition likelihood, yet has no impact on takeover premiums for firms that are acquired. These results do not support arguments that takeover defenses facilitate the eventual sale of IPO firms at high takeover premiums. Rather, they suggest that managers shift the cost of takeover protection onto nonmanagerial shareholders. Thus, agency problems are important even for firms at the IPO stage.     

A Model of Dynamic Takeover Behavior

Several observed features of takeover contests appear to be inconsistent with value-maximizing behavior on the part of the agents involved. For instance, managers occasionally resist takeover bids, presumably in order to facilitate competition among bidders. However, counterbids do not always materialize, suggesting that management resistance was not in the best interests of the firm's shareholders. On the other hand, a successful takeover is sometimes accompanied by a decrease in the value of the acquirer's shares. In addition, valuable combinations are occasionally not consummated. We present a simple illustration of sequential takeover bidding in which all managers act in the best interests of their respective shareholders. Within the context of this model, we provide an explanation of the type of behavior described above.     

Reducing managers’ incentives to cannibalize: Managerial stock options when shareholders are diversified

We analyze the relative advantage of option grants compared to stock compensation when shareholders are diversified. Our analysis recognizes a conflict that is largely neglected in the corporate finance literature. Shareholders want to maximize their portfolio value while capital budgeting rules direct managers to choose projects that maximize firm (equity) value. Options can reduce this conflict by motivating managers to avoid projects that enhance the value of one firm at the expense of another firm. Also, in our framework, relative performance evaluation destroys value for shareholders as it encourages firms to engage in cannibalistic activity. Consistent with the predictions of our model we find that firms with lower insider ownership, higher institutional ownership, and lower leverage tend to provide more option grants as compensation to their executives.     

Value impact of debt issuances by targets of withdrawn takeovers

An existing finance theory predicts that managers of takeover targets will increase leverage to enhance managerial control which can, in turn, allow target managers to thwart a takeover attempt altogether. We find that targets significantly increase leverage, not only by issuing more debt, but also by repurchasing more equity. We also find that debt issuances by poorly performing target managers made between takeover announcement and withdrawal result in significantly negative abnormal returns at the time of the issuance, consistent with the entrenchment role of debt. On the other hand, debt issued by high-performing target managers is not found to result in these same negative returns. Additionally, we document that debt-increasing, poorly performing targets experience significantly more negative returns at withdrawal announcement, also followed by significantly negative post-withdrawal stock performance, while these negative effects are offset for high-performing targets. Overall, our findings suggest that managerial motivations to block takeover attempts with increased debt issuance differ and that these differences in motivation are recognized by the market.     

Financing and takeovers

This paper analyzes the interaction between financial leverage and takeover activity. We develop a dynamic model of takeovers in which the financing strategies of bidding firms and the timing and terms of takeovers are jointly determined. In the paper, capital structure plays the role of a commitment device, and determines the outcome of the acquisition contest. We demonstrate that there exists an asymmetric equilibrium in financing policies with endogenous leverage, bankruptcy, and takeover terms, in which the bidder with the lowest leverage wins the takeover contest. Based on the resulting equilibrium, the model generates a number of new predictions. In particular, the model predicts that the leverage of the winning bidder is below the industry average and that acquirers should lever up after the takeover consummation. The model also relates the dispersion in leverage ratios to various industry characteristics, such as cash flow volatility or bankruptcy costs.     

Takeover Defenses and Bargaining Power

For decades, academics have claimed that even friendly acquisitions are negotiated in the "shadow" of a hostile takeover bid. But interviews with senior M&A investment bankers provide a different picture of negotiated acquisitions. Determining which version is more representative of most deals is important because the academic assumption has been a main pillar of attempts to justify poison pills and other takeover defenses as ways of increasing the bargaining power of target companies' managements and the premiums received by their shareholders.
This article shows that takeover defenses can be justified as a value-maximizing control device in a simplified model with one buyer and one seller. But after taking account of four realities that are present in many if not most corporate M&A deals—alternatives away from the negotiating table (i.e., other potential targets), high costs of launching a hostile bid, information disparities, and managers with divided loyalties—the author demonstrates that only a fraction of friendly acquisitions are in fact negotiated in the shadow of a hostile takeover threat. This conclusion is reinforced by both empirical evidence and the commentary of M&A practitioners presented in the article.     

Appraisal rights and corporate disclosure during mergers and acquisitions

Target shareholders have the right to ask for a higher merger price if good news emerges after a merger agreement. This “appraisal right” varies with state law and was substantially strengthened in Delaware in 2007. I examine how target managers respond to changes in this right. If target managers represent target shareholders, the managers would be more likely to release good news, but I find they are more likely to withhold good news when appraisal rights are higher. This suggests agency problems and collusion on the part of target managers, and thus my paper adds to the larger literature that considers agency problems on the part of managers.     

Corporate governance roles of information quality and corporate takeovers

We examine the corporate governance roles of information quality and the takeover market with asymmetric information regarding the value of the target firm. Increasing information quality improves the takeover efficiency however, a highly efficient takeover market also discourages the manager from exerting effort. We find that perfect information quality is not optimal for either current shareholders’ expected payoff maximization or expected firm value maximization. Furthermore, current shareholders prefer a lower level of information quality than the level that maximizes expected firm value, because of a misalignment between current shareholders’ value and total firm value. We also analyze the impact of antitakeover laws, and find that the passage of antitakeover laws may induce current shareholders to choose a higher level of information quality and thus increase expected firm value.     

Why Hang on to Losers? Divestitures and Takeovers

We study the divestiture decisions of managers who care about their reputations. Managers' divestiture and investment decisions are publicly observable, but managers privately observe signals with respect to the future payoff distribution of investments they have initiated. We establish that in equilibrium there is too little divestiture. These inefficiencies create the opportunity for wealth-enhancing divestiture-motivated takeovers. A key result is that only managers of targets with “middle of the road” asset specificity should consider the takeover threat credible. These findings suggest that uniqueness of assets is an important determinant of both agency costs and takeover activity. Our analysis leads to several empirical predictions.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

THE LEGALITY OF THE SHAREHOLDER RIGHTS BY-LAW IN DELAWARE: PRESERVING THE MARKET FOR CORPORATE CONTROL

Just as some lawyers almost killed the takeover market with the invention of the poison pill in the 1980s, others are now about to reinvigorate it with another legal invention. The “shareholder rights bylaw,” which promises to be the next major legal battleground in the market for corporate control, aims to eliminate the current ability of target company boards of directors to block changes of control by keeping their poison pill defenses in place. The new bylaws require the poison pill (and other defensive measures) to expire automatically whenever the firm receives an allcash offer for 100% of the firm's stock at a price at least 25% above the prebid market price. The firm can keep its poison pill, but only if shareholders vote to keep it after receiving the offer. Although the legality of the share-holder rights bylaw has been challenged as an undue infringement on boards of directors' power to run companies, this article argues that their legality will be upheld for three reasons:

• ? First, shareholder rights bylaws merely reinforce the corporate manager's responsibility to manage the firm to maximize shareholder value.
• ? Second, Delaware and most other jurisdictions give shareholders the specific right to amend the bylaws of a corporation; and the shareholder rights by-law is a straightforward exercise of this explicit right granted to shareholders.
• ? Third, the adoption of shareholders rights by-law does not prevent the board of directors from advising share-holders to vote to reject a takeover bid, nor does it prevent shareholders from giving management the authority to use defensive mechanisms such as the poison pill.

As the article concludes, upholding this right of shareholders to choose whether a poison pill is used to block a takeover is critical to the vitality of the takeover market and, hence, to the preservation of the agency relationship between directors and shareholders. Upholding this right may also prove critical to Delaware's ability to maintain its predominance in the market for corporate chartering.     

Corporate Takeovers: Mode of Payment, Returns and Trading Activity

This paper examines the impact of takeover bids and, in particular, the method of payment to the shareholders of the target firms on the returns, trading activity and bid-ask spreads of target and bidding firms traded on the London Stock Exchange. It suggests that the shareholders of target firms benefit substantially from takeover activity while the shareholders of bidding firms do not suffer. The combined value of the firms engaged in takeover activity increases by a small percentage during the event period. However, the benefit from a takeover announcement to the shareholders of the target firm varies from year to year and has declined in the recent past. The magnitude of excess returns available to the shareholders is also dependent on the mode of payment. Prices of target (bidding) firms increase (decrease) most if the shareholders of the target firms are given an option to receive payment in shares or in cash. The findings also reveal that during the event period trading activity in target and bidding companies increases depending on the form in which payments to shareholders are made. In response to this increased liquidity, the bid-ask spreads of target and bidding firms decline during the event period.     

UNIVERSAL BANKS ARE NOT THE ANSWER TO AMERICA'S CORPORATE GOVERNANCE "PROBLEM": A LOOK AT GERMANY, JAPAN, AND THE U.S.

This article objects to a recent tendency of legal and economic scholars to "romanticize" the corporate governance role of German universal banks and Japanese main banks. There are potential conflicts between banks' interests as lenders and as shareholders that are likely to make banks less-than-ideal monitors for outside shareholders. Citing evidence that Japanese corporate borrowers pay above-market interest rates for their bank financing, Macey and Miller interpret the high interest rates as "rents" earned by Japanese banks on their loan portfolios in exchange for (1) insulating incumbent management of borrower firms from hostile takeover and (2) accepting suboptimal returns on their equity holdings.
The main problems with the German and Japanese systems stem from their failure to produce well-developed capital markets. Concentrated and stable shareholdings reduce the order flow in the market, thereby depriving the market of liquidity. And the lack of capital market liquidity– combined with the intense loyalty of the banks towards incumbent management–removes the ability of outside shareholders to make a credible threat of takeover if managerial performance is substandard.
The problem with American corporate governance–if indeed there is one–is not that hostile takeovers are bad, but that there are not enough of them due to regulatory restrictions and misguided legal policies. While U.S. law should be amended to give banks and other debtholders more power over borrowers in the case of financial distress, encouraging U.S. banks to become large stockholders is not likely to improve corporate efficiency. Strengthening the "voice" of American equity holders by eliminating restrictions on the market for corporate control would be the most effective step in improving firm performance.     

Stock selling during takeovers

Stock sales during takeover negotiations weaken the target board's ability to recommend against the takeover, i.e., to resist. Sophisticated shareholders therefore face a coordination problem when deciding whether to sell-out early; and their actions generate a feedback loop between trading volumes and takeover outcomes. Bidding firms, anticipating the pressurising effect of future share sales on the target board, may reduce their bids. We study these tensions theoretically. We find that increasing the influence of shareholders during the bidding process lowers equilibrium bids; elongates the bidding process; but raises the overall probability of bid acceptance; and raises expected premia for unsophisticated shareholders.