Corporate Takeovers and Economic Efficiency

In the paper, Corporate Takeovers and Economic Efficiency, written for the Annual Review of Financial Economics, I review recent takeover research which advances our understanding of the role of M&A in the drive for productive efficiency. Much of this research places takeovers in the context of industrial organization, tracing with unprecedented level of detail “who buys who” up and down the supply chain and within industrial networks. I also review recent research testing the rationality of the bidding process, including whether the sales mechanism promotes a transfer of control of the target resources to the most efficient buyer. This literature draws on auction theory to describe optimal bidding strategies and it uses sophisticated econometric techniques to generate counterfactuals, exogenous variation, and causality. The review is necessarily selective, with an emphasis on the most recent contributions: half of the referenced articles were drafted or published within the past five years.

I divide the research into six areas. The first links finance and industrial economics. The competitive drive to establish a comparative advantage in production has proven resilient in the face of regulatory barriers, speeding up when those barriers come down, creating wave-like patterns in industrial merger activity. The process of “eliminating deadwood” is observed directly in the form downsizing excessively diversified businesses, and in the restructuring of firms in economic or financial distress. Studies tracing individual plant sales find direct evidence that buyers tend to be more efficient plant operators than sellers whether the parent is healthy or in financial difficulty. Possibly to take advantage of this efficiency gain, restructuring under the protection of Chapter 11 bankruptcy in the U.S. has over the past decade increasingly used the sales mechanism to resolve conflicts among claimholders, an interesting area for further research.

The M&A literature estimates production efficiency effects at the plant level, and a recent contribution is to define industry relatedness using text-based analysis to identify products as well as entire industry networks. This empirical literature concludes that takeover activity likely enhances production efficiency along the supply chain, and that the search for a merger partners is often driven by a desire to promote new product development. Moreover, the distribution of merger-induced wealth effects for the merging firms’ rivals, upstream suppliers and downstream customers appears inconsistent with the hypothesis that takeovers tend to promote the accumulation of market power (of the type traditionally concerning antitrust authorities).

Next, I review recent papers estimating effects of takeovers on corporate innovation. This literature quantifies corporate innovation activity using large-sample databases containing the number of patents as well as patent citations of bidders and targets. The quality of this research is such that it helps settle a controversy that goes back at least to the era of hostile takeovers in the early 1980s. A claim heard often then, and sometimes also today when defending against unsolicited takeover bids, is that takeovers prevent managers from implementing “long-term” investments. However, contrary to this claim, the current empirical tests conclude that takeovers tend to promote corporate R&D expenses and valuable innovations—conventionally regarded as “long-term” investments. This is particularly evident among smaller firms aiming to become targets of larger organizations. It appears that the prospect of being acquired by a larger firm (with scale-economies in later-stage production development, marketing and distribution) incentivizes smaller firms to innovate more intensely.

Third, an important branch of the literature deals with various aspects of the takeover mechanism itself—how firms are sold. This includes evidence on deal initiation, contractual provisions designed to allow revelation of proprietary information to the negotiating parties, as well as final deal terms and offer success rates. This research reveals a high degree of standardization and professionalization of the takeover process—the takeover mechanism is supported by professional middlemen and a set of standardized deal terms which is efficiency enhancing. The sales process attracts takeover bids which have been shown in several respects to confirm to the predictions of rational bidding theory. Importantly, this process has promoted targets seeking a merger partner to initiate deals themselves—rather than waiting around for a suitor—at an unprecedented rate. Over the past decade, deals involving public targets are initiated by the target board almost as often as by the bidder. An interesting but hitherto unresolved research question is whether this high rate of seller-initiated takeovers reflects the virtual “lock-down” of independent companies afforded by today’s strong takeover defenses afforded, e.g., by the combination of poison pills and staggered boards. With bidders on the fence, sellers may have to go on the offense.

Fourth, there is ongoing debate over the question: does the takeover selling process causes deal terms to be “market driven”? A major concern is whether bidders are able to exchange overpriced stock for “hard” target assets, causing the most overvalued rather than the most efficient bidder to gain control of the target resources. Recent empirical tests, which instrument bidder pricing errors using pricing shocks that are exogenous to bidder valuation fundamentals, reject this “opportunistic bidder financing” hypothesis. Moreover, additional model-based tests reject the notion of a costly feedback loop from changes in target market prices to deal terms during merger negotiations—another way bids may have been “market driven”. More specifically, these additional empirical tests reject the notion that target stock price run-ups just prior to takeover deal announcements increase the cost of the takeover for the bidder.

Fifth, there is renewed interest in auction theory in providing optimal bidding strategies in specific takeover settings, including tender offers, bilateral merger negotiations, and minority freeze-outs. Recent empirical studies present some evidence consistent with rational strategic bidding behavior, focusing on toehold bidding, preemptive bidding, coercive bidding and winner’s curse avoidance. Moreover, this branch of the literature contrasts the optimal bidding strategies of industrial and financial buyers (where the latter are private equity firms).

Finally, I turn to the perennial debate over bidder shareholder gains from takeover activity. Direct evidence on the wealth effects of mergers presents an important check on the assumption of value-maximizing corporate behavior driving economic efficiency. Traditional estimates show large gains to the seller but near-zero average gains for buyers (after transaction costs). However, recent work take issue with the implicit assumption behind traditional estimates that assume bidder stand-alone values are unchanged throughout the takeover process. Quasi-experiments as well as structural estimation techniques designed to identify the (counter-factual) bidder stand-alone value changes suggest that bidder takeover gains may be significantly greater than previously thought. Finding ways to accurately estimate the counter-factual bidder stand-alone value change in successful merger deal present an interesting and important challenge for future takeover research.

The full paper is available for download here.