Inefficient Results in the Market for Corporate Control

In my article on Inefficient Results in the Market for Corporate Control: Highest Bidders, Highest-Value Users and Socially-Optimal Owners, I argue that, unlike in most other markets, in the market for corporate control allocating resources to the highest bidder will often not produce an efficient result. That is, because of unusual features of that market, the party willing to pay the highest price to acquire the target (the highest bidder), the party who would derive the greatest private benefit from owning the target relative to the status quo (the highest-value user), and the party whose ownership of the target produces the greatest net social benefit (the socially-optimal owner) need not be, and often will not be, the same party. Consequently, allocating the target to the highest bidder will often produce an inefficient result.

The argument begins from the observation that, for most target companies, there are multiple potential strategic acquirers. In general, such parties are willing to pay to acquire the target because ownership of the target’s assets will confer on them a competitive advantage in their product markets and thus increase their future profits. Each such bidder will thus value the target at the present value of the incremental future profits that it expects to earn if it acquires the target, with the bidder having the highest such valuation being the highest-value user of the target.

When one strategic bidder acquires the target, however, other strategic bidders may incur significant costs because the winning bidder can exploit the competitive advantage that ownership of the target confers in ways that will reduce the future profits of losing bidders. For example, the winning bidder may be able to increase its market share at the expense of losing bidders or be able to lower prices in the product market thus compressing competitors’ operating margins. Transactions in the market for corporate control thus tend to produce significant negative externalities for losing strategic bidders. These externalities are merely pecuniary, however, because they are necessarily balanced by benefits received by the winning bidder or by customers in the product market. Such externalities are thus irrelevant to efficiency and should not affect how the target is allocated.

Nevertheless, because they seek to maximize their private wealth and not social welfare, bidders will pay dollar-for-dollar to avoid suffering such externalities. A bidder who expects to suffer a pecuniary externality by losing the bidding contest will thus increase its bid up the sum of its valuation of the target plus the externality that it expects to suffer from losing the bidding contest. Thus, the highest bidder will be not the party with the greatest valuation of the target but the party for whom the sum of its valuation of the target plus the pecuniary externality that it expects to suffer from losing the bidding contest is greatest. The highest bidder will thus not necessarily be the highest-value user.

Furthermore, when the successful bidder uses the target’s assets in its business, it generally creates benefits for customers in its product markets by, for example, reducing prices or improving the quality of goods. Thus, transactions in the market for corporate control also generally produce significant positive externalities. These are real benefits and not mere pecuniary ones, and they are thus relevant to an efficient allocation of the target. But since these benefits are captured by customers in the product market and not by the successful bidder, bidders will not impound their value into their bids. The socially-optimal owner of the target will thus not necessarily be the highest bidder or even the highest-value user; rather, the socially-optimal owner will be the party for whom the sum of its valuation of the target plus the real positive externalities that its ownership of the target will generate for customers in the product market, net of costs to losing bidders, is greatest.

When strategic buyers compete to buy a target company, therefore, the price that a bidder will pay is thus distorted both upwards, because it impounds the negative pecuniary externalities that the bidder will suffer if it fails to acquire the target, and downwards, because it does not impound the positive real externalities that customers in the product market will enjoy if the bidder succeeds in acquiring the target. Since there are multiple potential strategic buyers for the great majority of target companies, such distortions are very common in the market for corporate control. Moreover, as simplified but plausible examples show, the distortions can be very large, even amounting to a significant fraction of the purchase price for the target. Because of these distortions, even after a free and unfettered bidding contest in the market for corporate control, allocating a target company to the highest bidder will often be inefficient.

These results have very wide implications. Among other things, they provide a completely new explanation for the well-known empirical findings that acquirers tend to overpay in corporate acquisitions. They show that classical auction theory, which assumes that bidders set their bids without regard to the identity of other bidders, does not apply to the market for corporate control. And they show that the concerns of courts and scholars about the allocative effects of antitakeover devices and deal protection devices, while real, are less important than previously believed because distortions arising from such devices will often be significantly smaller than the distortions identified in this article.

Returning to the main result that allocating a target company to the highest bidder may produce in an inefficient result, the article then considers some possible policy responses to such misallocations. The article concludes that detecting corporate control transactions that misallocate resources because of the distortions identified in the article is extremely difficult. In particular, any attempt to do so by a government agency seeking to prevent such misallocations would be subject to a very high error rate, and the costs of errors would generally also be very high. Hence, the costs of detecting and prohibiting corporate control transactions that misallocate resources because of negative pecuniary externalities or positive real externalities distorting prices in the market for corporate control are likely greater than the benefits that could be captured by attempting to block suboptimal transactions. From a social point of view, the best solution may be to suffer the costs of such misallocations.

The full article is available for download here.