Do Takeover Defenses Deter Takeovers?

Jonathan Karpoff is Professor of Finance at the University of Washington. This post is based on an article authored by Professor Karpoff; Robert Schonlau, Assistant Professor of Finance at Brigham Young University; and Eric Wehrly, Finance Instructor at Seattle University. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen and Allen Ferrell (discussed on the Forum here), The Costs of Entrenched Boards by Lucian Bebchuk and Alma Cohen, and The Case Against Board Veto in Corporate Takeovers by Lucian Bebchuk.

The G-index and E-index are workhorses of empirical corporate finance research. Each counts the number of takeover defenses a firm has and is often used as a summary measure of the firm’s protection from unsolicited takeover bids. But do these indices actually measure takeover deterrence?

This is an important question because a substantial number of empirical findings and their interpretations are based on the assumption that takeover defense indices do indeed measure takeover deterrence. For example, researchers have used the G-index and E-index to examine whether takeover defenses are associated with various firm outcomes including low stock returns, low firm value, acquisition returns, takeover premiums, increased risk taking, internal capital markets, credit risk and pricing, operating performance, the value and use of cash holdings, and corporate innovation. Researchers also have used takeover indices to examine whether takeover defenses serve primarily to entrench managers at shareholders’ expense, or to increase firm value through bargaining or contractual bonding.

The common basis in all of these tests is the foundational assumption that the G-index and/or E-index measure takeover deterrence. Yet almost no empirical evidence exists that quantifies whether, or how much, various takeover defenses or combinations of defenses actually affect a firm’s takeover likelihood. In our paper, Do Takeover Defenses Deter Takeovers?, recently made publicly available on SSRN, we provide the first direct evidence consistent with a causal relationship between takeover defense indices and takeover deterrence.

Our paper first shows that in simple tests that do not account for endogeneity; the G-index and E-index are not significantly related to takeover likelihood. This result runs counter to the foundational assumption of a deterrence effect.

Researchers in this area have long grappled with the problem of endogeneity. Firms that deploy takeover defenses may do so precisely because they are likely to receive unsolicited takeover bids. The absence of an empirical correlation between takeover defenses and firm independence cannot rule out the hypothesis that takeover defenses do in fact deter takeovers, but tend to be deployed by firms with high takeover likelihoods. Stated differently, the lack of an empirical correlation between defenses and takeover frequencies might simply indicate that the defenses are endogenous, not ineffective. We address the endogeneity problem using two new instruments for a firm’s use of takeover defenses based on the firm’s geography and IPO cohort. Following guidelines discussed in the literature, we test and confirm that both our instruments meet the necessary conditions for the identification of strong instruments. Using these instruments to account for endogeneity has an important effect on our empirical results, as we find that takeover likelihood is negatively and significantly related to both the G-index and E-index. A one-standard deviation increase in the instrumented value of a firm’s G-index results in an 8.1% reduction in the probability that the firm will be acquired within five years. A one-standard deviation increase in the instrumented value of a firm’s E-index reduces the probability that the firm will be acquired within five years by 8.8%. These results are robust to several different methodological approaches to modeling the relation between takeover likelihood and provision use. These results provide the first direct empirical support for the widespread assumption that takeover defenses do in fact deter takeovers.

We also investigate the effects of individual provisions within the indices. The relation between takeover likelihood and the G-index is driven by a subset of 14 provisions, many of which are not captured by the E-index, and four of which have impacts on takeover likelihood opposite to how they are counted in the G-index.

The ten provisions that are associated with lower takeover likelihood after controlling for endogeneity are anti-greenmail provisions, classified boards, director indemnification, limitations on director liability, directors’ duties provisions, director contracts, fair price restrictions, cashout laws, supermajority requirements, and unequal voting rights. The provisions that are positively related to takeover likelihood are compensation plans with change-in-control provisions, golden parachutes, limitations on written consent, and straight (i.e., not cumulative) voting. The fact that these four provisions are positively related to takeover likelihood runs counter to the assumptions behind the widespread use of the G-index and suggests further research is warranted. Based on these findings, we propose an empirically-driven subset of 14 takeover defenses that better reflects a firm’s takeover defense posture than previous indices.

Poison pills are notably absent from our list of provisions that are empirically related to takeover likelihood. This is because all firms to some degree have a shadow pill (i.e., the ability to quickly adopt a pill without shareholder approval) during our sample period. Because there is no effective cross-sectional difference in firms’ coverage by poison pills during our sample period, our empirical method cannot identify the effect that poison pills likely have on takeover likelihood. Our results indicate that the above 14 provisions have incremental effects on takeover likelihood over and above any deterrence effect of poison pills.

The full paper is available for download here.

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