Entry Competition in Takeover Auctions

Matthew Gentry is Lecturer in Economics at the London School of Economics & Political Science and Caleb Stroup is Assistant Professor at Davidson College. This post is based on their recent article, forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here).

In our recent article titled, Entry and Competition in Takeover Auctions, just published in the Journal of Financial Economics, we investigate how the choice of sale mechanism affects fair value in corporate M&A transactions. In the past, negotiated sale prices were readily accepted as reliable evidence of a seller’s fair value (i.e., the highest reasonably-expected price). However, over time there has been increased scrutiny of sale processes by shareholders, Delaware Courts, and scholars in finance and economics, who have observed that deal premia might turn out to be higher if a company is sold via an auction-style process.

At the heart of this debate is lack of a clear understanding about whether fair value depends on the specific details of the sale process itself. For example, should target shareholders expect a higher sale price from an auction relative to a negotiated transaction? In the classic view, arms-length auction-style sale processes lead to higher prices, a view reflected by the injunction that directors act as “auctioneers” when selling their firm (Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986)). In this classic view, auctions are presumed to generate high prices via competition among a large pool of bidders for a selling company. This is because bidders face two types of pressure to raise their offer prices. The first is that target shareholders might walk away from the deal, the standard bargaining rationale present in negotiated transactions. The second is pressure from competing offers (i.e. from other bidders). In the classic view, auctions are expected to produce higher prices than negotiation-style transactions.

More recent research in financial economics has pointed out that negotiated transactions could in principle outperform auctions since a negotiating bidder might shade up its offer price to deter potential competitors. After all, the selling company can always walk away and negotiate with a different bidder, or even conduct an auction-style market-check (i.e., a “go-shop”). Even in the absence of a go-shop, sellers have the option to approach alternate bidders (Aktas, De Bodt and Roll, 2010). This implies such potential competition may not be a documentable feature of the sale process.

As we show, the pressure of such potential competition depends critically on the extent to which, prior to their entry into a sale process, potential buyers are unsure about their valuations for the selling company (i.e., prior to conducting due-diligence on the target). Given the costs of participating in takeover competitions, it is not surprising that more than half of potential bidders decline when invited to participate in auction-style sale processes. As we show, this lack of participation can impair auction performance relative to negotiated transactions.

Standard data on takeover prices are insufficient to understand the relative importance of these multiple effects on the relative performance of auctions and negotiated transactions. This is because selling companies and their advisors strategically determine how to sell their company, based in part on characteristics of the competitive landscape that may not be observable to researchers, such as the degree of information frictions faced by potential buyers. To overcome this problem, we manually collect data from SEC filings on characteristics of takeover sale processes, including participation patterns in auction-style transactions and use these data to estimate the relative magnitudes of the various channels that determine the relative performance of auctions, negotiations, and negotiations followed by auction-style market-checks.

Our main findings are as follows. First, we confirm that average sale prices are similar across observed auctions, negotiations, and go-shops. We show, however, that these averages mask important differences across companies in the revenue-generating power of auctions and negotiations: We show that some companies tend to obtain higher prices when sold via auctions, while others tend to obtain higher prices when sold via negotiations.

We show that the relative performance of auctions and negotiations depends predictably on characteristics of the selling company, such as its size and leverage, that are observable by shareholders, advisors, and Delaware courts. For example, we show how the relative performance of auctions, negotiations, and go-shops varies systematically across industries and with selling company characteristics: auctions should be more frequently used in industries where target value is less transparent, such as consumer products and finance, while negotiated transactions are more frequently preferred in industries where target value is more concrete, for example oil, gas, coal, and chemicals. We also show that selling company variables predicting uncertainty about fair value (e.g. company size and leverage) tend to result in auction outperformance relative to legitimatizations, while the reverse is true for variables like cash holdings that are associated with greater clarity in valuation prior to conducting due-diligence.

Our framework also shows how information frictions account for the observed relationship between firm characteristics and the relative performance of auctions and negotiations. Potential bidders’ uncertainty about target value encourages entry, and thus competition, in takeover auctions. Conversely, by reducing bid-sharing pressure from potential competitors, information frictions reduce a selling company’s bargaining power. Taken together, these findings imply that auctions tend to produce higher prices in takeover markets with high pre-entry uncertainty, while the reverse is true for negotiations.

The complete paper is available for download here.

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