(Ir)responsible Takeovers

Doron Levit is the Marion B. Ingersoll Endowed Professor of Finance and Business Economics at the University of Washington Foster School of Business, and Philip Bond is a Professor of Finance and Business Economics at the University of Washington. This post is based on their recent paper.

Investors are increasingly prioritizing the societal impact of their portfolio companies and claim to incorporate environmental and social (E&S) factors into their investment decisions. The effectiveness of responsible investment strategies in shaping corporate policies is a topic of ongoing research and debate. In practice, big changes in corporate policy are often the consequence of being acquired, and indeed, these acquisitions not only affect  shareholder value, but also generate externalities for firms’ various stakeholders. The market for corporate control is therefore a natural domain for responsible investment to make an impact, and consistent with this view, recent evidence suggest that E&S considerations indeed play a role in the dynamics of deal-making.

In our recent paper “(Ir)responsible Takeovers,”  we study how responsible investment manifests itself in the market for corporate control. Should we expect the M&A market to push firms towards social efficiency? Or will we instead see socially responsible firms expose themselves to the threat of takeovers by less-socially-minded acquirers?

Consider the energy company BP, which is diversifying away from fossil fuels faster than its peers.  Perhaps as a consequence, its share price has underperformed peers, and the financial press repeatedly mentions it as a potential acquisition target.  If BP’s shareholders indeed value the reduction in carbon emissions that BP’s diversification policy promises, how feasible would it be for another firm to acquire BP, with the intent of increasing BP’s profits post-acquisition by abandoning BP’s diversification policy?

Concretely, BP’s shares currently trade at approximately $32.  Suppose that an acquirer could boost this value to $42 by abandoning diversification.  Suppose further that each shareholder dislikes the carbon emissions that would flow from abandoning BP’s diversification policy by a monetary equivalent of $15.  Would shareholders accept an acquisition offer of, say, $40?

If shareholders were able to coordinate their actions, then they would clearly decline the offer; the $8 offer-premium is smaller than the $15 harm that shareholders would suffer from a shift to more carbon-intensive corporate policies. But this coordinated outcome is vulnerable to the standard problem of free-riding in public good provision.  Dispersed shareholders are tempted to compare the $8 offer-premium with the fact that, individually, their tendering decisions have little influence over the takeover outcome.  This reasoning results in under provision of the public good, i.e., shareholders too ready to accept the acquirer’s offer.

Importantly, there is a second free-rider problem at play, namely an individual shareholder’s temptation to “hold out” and retain their shares, reasoning that if the acquisition succeeds the share price will rise to $42, exceeding the $40 offer (Grossman and Hart 1980).  This reasoning makes shareholders reluctant to accept the acquirer’s offer.

How do these two free-rider problems interact?  This is exactly the question that we study in our paper. We do so by introducing externalities and social preferences into the canonical takeover model of Bagnoli and Lipman (1988). Our framework allows for situations where a takeover is socially inefficient but privately efficient, and vice versa. Importantly, target shareholders’ preferences consider both the value of their shares and the firm’s externalities.

In the benchmark case of fully-consequentialist shareholders who care about the target firm’s externalities regardless of whether they own its shares, we show that the two free-rider problems have the same force and offset each other, and consequently, efficiency is achieved.

In the BP example, this leads shareholders to reject any offer the acquirer would be willing to make—even the maximum offer premium of $10 is less than the $15 social cost of the takeover.  Conversely, if an acquirer were able to raise BP’s value by $20 to $52/share, then it could afford an offer premium above $15, and in this case enough shareholders would accept the offer for the acquisition to succeed with positive probability.  In general, the dual free-rider problems imply that socially inefficient (efficient) takeovers fail (succeed) even if they are privately efficient (inefficient). This result holds no matter how dispersed shareholders are and even though the bidder’s sole objective is maximizing profits from the takeover.

In practice, shareholders often appear to attach special importance to the social harms generated by their portfolio companies. We show that departures from full-consequentialism result in an inefficient market for corporate control. For example, it makes a takeover easier in the BP-scenario that we’ve been discussing.  Specifically, shareholders would be much less tempted to “hold out” in the hope of profiting from a successful acquisition.  The reason is that hold-out shareholders are stuck with shares in a now-dirty company, while the alternative is to tender and receive the offer premium while also divesting.  As such, shareholders who focus narrowly on the social harms of portfolio companies engender acquisitions that cause social harm.  Moreover, and even more starkly, such shareholders effectively prevent acquisitions that create social benefits from occurring. The reason is that an acquisition that creates social benefits creates an especially severe hold-out problem, because a hold-out shareholder not only compares the offer-premium with the monetary value created by the takeover, but also compares the “warm glow” that comes from retaining shares in a socially virtuous firm with the absence of such feelings associated with tendering.

Building on these insights, we extend our analysis by allowing the profit-maximizing bidder (loyal incumbent) to choose a policy that will increase the value of the firm post-takeover (pre-takeover) while creating negative (positive) takeover externalities. We show that under full-consequentialism, bidders (incumbents) will commit to producing the efficient level of externalities post-takeover (pre-takeover), reinforcing our first efficiency result. In other words, from the bidder’s perspective, social responsibility is a profit-maximizing strategy, and from the incumbent’s perspective, social responsibility is an effective takeover defense.

By contrast, we show that with “warm-glow” preferences, the bidder has incentives to create more value at the expense of producing larger negative externalities than it is socially optimal. In the BP example, a potential suiter can benefit from threatening BP’s shareholders to abandon BP’s diversification strategy after the acquisition, and in this respect, social irresponsibility is an effective and profitable bidding strategy.

Finally, we consider cases in which the motivation of the bidding firm (or its own shareholders) for a takeover goes beyond profit. We show that the bidder’s social responsibility “adds” to the target shareholders’ social responsibility. Specifically, under full-consequentialism, a bidder’s social responsibility can be counterproductive and reduce efficiency of takeover outcomes. However, if target shareholders exhibit “warm-glow” preferences, then the bidder’s social responsibility can increase efficiency of takeover outcomes. Combined, the efficiency of the market for corporate control depends on the social preferences of both counterparties, and more social responsibility is not always better.

Overall, our analysis demonstrates that externalities in takeovers and social responsibility have significant positive and normative implications for the market for corporate control.

The paper is available here: (Ir)responsible Takeovers.

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