Cherry Picking in Cross-Border Acquisitions

E. Han Kim is a Professor of Finance at the University of Michigan.

In the paper, Cherry Picking in Cross-Border Acquisitions, my co-author (Yao Lu of Tsinghua University) and I investigate how investor protection (IP) affects the allocation of foreign capital inflows at the firm level. A simple model provides an explanation for a well documented but little understood phenomenon on international capital flows—the tendency of foreign investors to target better-performing firms in emerging markets.

When a foreign acquirer’s country has stronger IP than a target country, the acquirer’s controlling shareholder values private benefits of control less than controlling shareholders of local firms because stronger IP imposes greater constraints on diversion of corporate resources for private benefits. Within the target country, controlling shareholders of firms with more profitable investments take fewer private benefits and, hence, demand lower control premiums. Foreign acquirers, which value control premiums less, will target firms with more profitable investments. The tendency to cherry pick will intensify (moderate) as the IP gap between the acquirer and target countries increases (decreases).

This prediction is tested with data on cross-border acquisition bids. Of 33 acquirer and target countries in our sample, 20 countries undertook corporate governance reforms (CGRs). These CGRs, which took place in a staggered fashion, generate within-country variation in IP, allowing identification of the effect of changes in the IP gap between acquirer and target countries. Consistent with the prediction, we find a significant increase in the cherry-picking tendency after strong-IP acquirer countries increase the IP gap by undertaking CGRs.

We also find CGRs undertaken by target countries reduce foreign acquirers’ tendency to cherry pick. These findings imply weak IP in target countries prevents poorly performing firms from gaining access to foreign investors, restricting the spread of the potential benefits of globalization. More generally, they highlight the importance of IP in guiding international capital flows not only across countries, but also across firms within a country.

Recent studies demonstrate that cross-border acquisitions are an important channel to spread corporate governance systems from strong to weak legal regimes (e.g., Rossi and Volpin, 2004; Bris and Cabolis, 2008; Chari, Ouimet, and Tesar, 2010). This paper identifies an important distortion in that channel. Cherry picking implies the transmission of governance systems through cross-border acquisitions occurs mainly for better performing firms, leaving largely untouched poorly performing firms, which may be in greater need of governance improvement. Improving the legal environments of weak-IP capital-importing countries should help alleviate the distortion.

The full paper is available for download here.

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