Managerial Control Benefits and Takeover Market Efficiency

Wenyu Wang is Associate Professor of Finance at Indiana University Kelley School of Business and Yufeng Wu is Assistant Professor of Finance at University of Illinois at Urbana-Champaign Gies College of Business. This post is based on their recent paper, forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes Why Firms Adopt Antitakeover Arrangements by Lucian Bebchuk.

The takeover market plays a crucial role in reallocating assets and stimulating economic growth. In 2016 alone, public firms in the United States exchanged $600 billion worth of assets, which accounted for 32% of their total investments. Much of this asset reallocation is shaped by entrenched managers’ preferences for acquiring control benefits. As Jensen and Meckling (1976) point out, these preferences can destroy significant value in the market for corporate control. However, at the same time, it is likely that incumbent managers’ fear of losing their control benefits also generates a bright-side effect: intuitively, when managers enjoy high control benefits, they have an ex ante incentive to work harder when the firm underperforms to avert a takeover threat.

In this study, we revisit how the efficiency of the takeover market is influenced by managerial control benefits, quantifying both the traditional losses in value that stem from managers’ desire to gain more control and the positive effects of control preferences on incentivizing managerial effort. Our empirical methodology is structural estimation, which is an attempt to fit an economic model to the data, assess how well the model fits the data, and measure fundamental economic parameters. This methodology is common in certain fields of economics, such as industrial organization, and it is becoming more popular in corporate finance.

We estimate a structural model that embeds the classic q-theory of M&As—acquirers can partially transfer their technology and organizational structure to the targets after takeovers. Our setup also allows takeovers to create value through other sources of synergy (e.g., asset complementarity). We incorporate managerial control benefits as a main source of friction in the model. In particular, the board is motivated to pursue M&As not only to create synergy for its shareholders, but also to increase control benefits for its managers. The dark-side effect of managerial control benefits therefore arises from the conflict of interest between shareholders and the manager: some value-destroying deals are pursued to create control benefits for acquirer managers, whereas some value-enhancing deals are blocked to protect target managers. Meanwhile, the bright-side effect of managerial control benefits arises from their impact on takeover threats. Managers who enjoy high control benefits suffer a substantial loss if their firms are acquired, and thus they would exert more effort when their firms underperform and are exposed to greater takeover threats. The control benefits therefore materialize managers’ fears of being replaced and amplify the disciplinary effect of the takeover market.

We estimate the model using a large sample of US public firms from 1980 to 2015. Consistent with the common belief in the literature, we find that managers’ control benefits create a dark-side effect by distorting asset reallocation, leading to 17% of value-destroying takeovers being pursued and 12% of potential value-enhancing takeovers being blocked. In contrast, the bright-side effect induces managers to exert higher effort and speeds up the firms’ self-recovery rate by 14%. Overall, the bright-side effect increases the value created by an active takeover market by 21%, which is comparable in magnitude to the dark-side effect emphasized in the literature.

We also document significant cross-sample variations in the two effects. Among firms with good performance and entrenched managers, the dark-side effect is more pronounced, leading to more value-destroying mergers being completed and larger overpayment when these firms act as acquirers. Eliminating managers’ control benefits among these firms would enhance their value by 4%. On the contrary, among poorly performing firms with less-protected managers, the bright-side effect dominates, making the takeover threat a more effective governance mechanism. For these firms, eliminating their managers’ control benefits would reduce firm value by 3%, mainly through a much weaker disciplinary effect from the takeover market.

In addition, our findings reveal that both the dark-side and the bright-side effects of managerial control benefits can lead to a low takeover-performance sensitivity. Due to the dark-side effect, underperforming firms whose managers have high control benefits are more resistant to takeovers and thus are less likely to be acquired; due to the bright-side effect, these firms can recover more rapidly by themselves with increased managerial effort. Thus, they rely less on the realized takeovers as a rescue. The two forces jointly dampen the takeover-performance sensitivity by a half, leading to a weak relation that is consistent with the data. This finding, however, suggests that the takeover-performance sensitivity is a poor measure for the efficiency of the takeover market, because it cannot differentiate between the two effects that have opposite implications on the value of the takeover market.

Last, we augment our analyses by incorporating various internal governance practices. Our results suggest that there is some degree of substitutability between the external governance provided by the takeover market and the firms’ internal governance practices, such as pay/turnover for performance, and the substitutability is particularly strong for underperforming firms with less-protected managers. Our study suggests that these firms should fully exploit the takeover threat as a cost-efficient way to incentivize their managers.

To summarize, we find that managerial control benefits create two opposing effects on the efficiency of the takeover market, and they vary substantially across firms with different economic standing and managerial characteristics. Determining how firms, in reality, choose the optimal mix of internal versus external governance practices could be an interesting topic for future research.

The complete paper is available for download here.

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