Excerpt
Table of Contents
1. Introduction
2. The Market for Corporate Control – A definition
2.1. Corporate Control
2.2. The Market for Corporate Control
3. Why are takeovers needed?
3.1. The failure of internal controls
3.2. Hostile takeovers as disciplining devices
4. Taking over corporate control
4.1. Three takeover devices for the acquirer
4.1.1. Proxy Fight
4.1.2. Direct Purchase
4.1.3. Merger
4.1.4. Summary
4.2. Defense devices for the incumbents
5. Corporate Control takeover motives
5.1. Managerial efficiency hypothesis / Creation of market power hypothesis
5.2. Hubris hypothesis and the egoistic, overpaying manager
6. The welfare effects of corporate takeovers
6.1. Costs of a corporate takeover
7. Discussion: Does the market for corporate control work?
7.1. Solving problems of takeovers
8. Conclusion
References
List of Tables
Table 1 Abnormal percentage stock price changes associated with succesful corporate takeovers (Jensen & Ruback, 1983, p. 4; adapted by the author)
Table 2 Abnormal percentage stock price changes associated with unsuccessful corporate takeover bids (Jensen & Ruback, 1983, p. 4; adapted by the author)
Table 3 Classification of mergers by firm size in year t+5 (Gugler et al., 2003, p. 650; adapted by the author)
List of Abbreviations
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1. Introduction
The separation of ownership and control in organizations as it is present in many of today’s existing firms and common in most publicly listed corporations, leads various parties such as economists, lawyers, shareholders and managers likewise to various questions regarding the efficiency of this approach.
As Berle and Means (1982) already pointed out in the initial 1932-issue of their book “The Modern Corporation and Private Property” important decision agents, namely the managers of corporations, do not bear a substantial share of the wealth effects of their decisions. Hence, various questions regarding the governance of these corporations have arisen. Scientists and practitioners since then are seeking for answers on questions like: How can directors of corporations be incentivized to act in the best interest of their shareholders, namely the maximization of the value of a company? How can the resources of a corporation be used in the most efficient way in order to generate the highest value possible out of them? Which mechanisms exist to transfer the control in corporations from one party to another?
The market for corporate control, often referred to as the takeover market, provides answers to these questions. The theory of the market for corporate control explains how this market facilitates the transfer of control over the management of a corporation’s assets from one party to another.
Though the academic discussion on whether such a market exists, what welfare effects it bears, and how it can be used to answer the above asked questions was initiated by Manne (1965) almost fifty years ago, the necessity for efficient mechanisms to ensure the accountability of corporate directors to their investors, today is greater than ever, as spectacular, current examples of management fraud and highly costly investments of managers show. (cf. Fockenbrock, 2012; Healy & Palepu, 2003)
This paper will, starting with Manne‘s (1965) initial essay on the topic, introduce the theory of the market for corporate control. Therefore, I will begin with a definition of the terms “corporate control” and “the market for corporate control”. Following this, I will explain the possibilities of taking over the control of a corporation. Subsequently, I will argue why the market for corporate control is of great importance. Afterwards, a synopsis on the current empirical evidence of its efficiency follows. Finally, I will take a look on the welfare effects of the market for corporate control, before concluding on its applicability and having a look on solutions to correct the imperfections of the model.
2. The Market for Corporate Control – A definition
2.1. Corporate Control
The term corporate control in a broader sense is used to describe the various forces that influence the behavior of a corporation. This ranges from legal and regulatory systems, competition in product and factor markets to the control of a majority of seats on a corporation’s board of directors (cf. Jensen & Ruback, 1983, pp. 1-2).
In a narrower sense, corporate control can be defined as the active control of a corporation’s capital. The term “capital” includes all corporate assets, ranging from human resources, over physical assets to specific knowledge within a corporation. As Jensen and Ruback (1983, p. 2) define it, “corporate control is the right to determine the management of corporate resources” – that is “the power to hire, fire, and compensate the top-level decision managers and to ratify and monitor important decisions” (Fama & Jensen, 1983, p. 14).
“When a bidding firm acquires a target firm, the control rights to the target firm are transferred to the board of directors of the acquiring firm. While corporate boards always retain the top-level control rights, they normally delegate the rights to manage corporate resources to internal managers. In this way the top management of the acquiring firm acquires the rights to manage the resources of the target firm.” (Jensen & Ruback, 1983, p. 2)
2.2. The Market for Corporate Control
The basic proposition advanced by the market for corporate control is that “the control of corporations may constitute a valuable asset” (Manne, 1965, p. 112). The market for corporate control assumes a “high positive correlation between corporate managerial efficiency and the market price of shares of that company” (Manne, 1965, p. 112).[1]
Whenever a company’s resources are not used to their possible full extent and hence the company’s value is not maximized under the current management, the market price of the shares of that company should then be lower than the price of its shares would be when using the resources to the best extent possible. The share price of a publicly listed company does not only comprise the current value of a company’s assets, including its current management, but as it also measures capital gains or expectations about the future performance of the listed company. This is of great importance, as with bad management, therefore low corporate efficiency and a resulting low stock price, a company becomes relatively more attractive for a take-over party, the so-called bidder, which thinks it could manage the target more efficiently. As Manne (1965, p. 113) states in his initial paper on the market for corporate control: “The potential return from the successful takeover and revitalization of a poorly run company can be enormous.”
Whereas Manne’s first presentation of the market for corporate control does not explicitly specify the entity bidding for the right for corporate control, later papers shift the view to managers as being the central entities within in the market. Jensen and Ruback (1983, p. 2), for example, view the market for corporate control “as a market in which alternative managerial teams compete for the rights to manage corporate resources”. Black (1989, p. 600) explains this similarly and says “that the market for corporate control is an arena where good managers can wrest control of corporate assets away from poor managers.”
3. Why are takeovers needed?
3.1. The failure of internal controls
“Much corporate behavior seems best understood in terms of managers running the show largely as they please.” (Shleifer & Vishny, 1988, p. 7)
Managers, as everyone else, have many different personal goals and ambitions that they pursue. One of those goals might be the desire to act in the interest of their shareholders, but apart from that, managers might as well desire a fortune, fame, praise, a relaxed life or something completely different. The way managers actually manage their companies is heavily influenced by their personal goals and ambitions. Shareholders, as being financiers only to the company, not actively managing it, do not have multiple goals and ambitions, but solely care about getting rich from the stock they own. (cf. Shleifer & Vishny, 1988, p. 7)
These different goals of managers and shareholders lead to agency problems within corporations and necessarily to conflicts whenever shareholders discover this behavior. That the separation of ownership and control within corporations leads to agency problems[2] is a phenomenon that was originally discovered by Berle and Means (1982) already in 1932. Since then, shareholders have different aids to ensure that their managers act according to their interest. However, as Shleifer and Vishny (1988, p. 7) find: “Much corporate behavior seems best understood in terms of managers running the show largely as they please.”
In organizations in which decision agents do not bear a major share of the wealth effects of their decisions boards of directors are used as the top control device to ensure that managers act efficiently and in the interest of their shareholders. The board of directors “always have the power to hire, fire, and compensate the top-level decision managers and to ratify and monitor important decisions.” (Fama & Jensen, 1983, p. 14) Even though, the board statutory could make use of those rights, it rarely will do so. As managers control the selection of the directors (cf. Mace, 1971) their independence from them can be doubted. Even if the board of directors is not chosen by the manager, it usually does not have sufficient information to judge whether projects are value-maximizing. Acquiring this knowledge can be highly expensive for the board.
Furthermore, it is probable that a manager will try to increase his value for the firm, as well as he might aim to make his removal more costly. By hiding valuable information on his own abilities, motives and possible outcomes of investment decisions from the board of directors he could so. A CEO might, for example, only invest in businesses he is good at running, thus proving his ability to run the company and making his reelection more probable. Even though those investments might not be the most efficient decisions for the corporation in general, they would increase the likelihood of an incumbent staying in office. (cf. Shleifer & Vishny, 1988, p. 9) Even though the board of directors has the formal power to hire and fire the management (cf. Fama & Jensen, 1983, p. 14), it is usually viewed as the incumbents privilege to choose a succeeding CEO. (cf. Shleifer & Vishny, 1988, p. 9)
A corporation’s board of directors might also be able to set up a compensation contract that incentivizes a value maximizing behavior of a manager. This could be done via paying a manager at least partly in stock options. As Shleifer and Vishny (1988, pp. 9-10) explain it, this option could lead to lawsuits by shareholders, hence not being an option that would be accepted by managers.
Another option of aligning the manager’s behavior with the goal of value maximization would be the possibility to bribe him, whenever it seems he is not serving that goal. But, if a manager can expect to receive a payment whenever it looks like he may not act in the interest of shareholders, he will have an incentive to create such situations. (cf. Shleifer & Vishny, 1988, p. 10)
Finally, there would be the option to compensate the manager according to the market value of the stock of his company. A manager would obviously be clearly incentivized to maximize value, if he would be rewarded for good stock performance and likewise penalized for a bad stock performance. Even though this is a legit concept, Shleifer and Vishny (1988, p. 10) find that there are no studies available that indicate that any of the incentives, build into managerial contracts, effectively discourage most non-value-maximizing behavior. This is supported by research of Jensen and Murphy (1986), who found out that the lifetime wealth of the average chief executive officer of a large firm increases by only about $1.40 for each $1000 increase in the market value of the firm.
To sum it up: Most of the existing internal control mechanisms that are used to ensure that managers act in the best interest of the shareholders, that is that they manage their company efficiently and maximize its value, are not effective. Most control devices presented above lack the necessary information to judge whether a manager is doing his job in the best manner possible.
3.2. Hostile takeovers as disciplining devices
Chapter 3.1. illustrated clearly that internal control devices largely fail to get managers to maximize the value of their corporations. This is where the market for corporate control offers a solution. As Manne (1965, p. 113) puts it: “Apart from the stock market, we have no objective standard of managerial efficiency.”
As the market for corporate control assumes a “high positive correlation between corporate managerial efficiency and the market price of shares of that company” (Manne, 1965, p. 112), given the fact that this correlation exists, a decline in share prices should signal a lowered managerial efficiency within a company. Manne (1965, p. 112) argues in his introductory paper on the market for corporate control that there would not be an objective standard for managerial efficiency. However, he finds that the stock market could be used as a measure for corporate managerial efficiency as there would be “reason to believe that intelligence rather than ignorance ultimately determines the course of individual share prices.” (Manne, 1965, p. 112) The reasoning for this is the fact that over a long period of time bid or non-bid choices of potential shareholders, who make their decisions without reliable information, would tend to be randomly distributed. Their choices would then not influence the stock price. But then again, investment decisions made by better informed bidders would steer a share’s price to the “correct” one over a longer period of time.
As Maug (1998, pp. 66, 88-89) shows empirically for large shareholders, a liquid stock market could facilitate the exercise of corporate control in two ways. First, a liquid stock market, according to Maug, would allow large shareholders to emerge to correct managerial failure. Second, large shareholders would be able to sell their shares before an expected fall in stock prices. They would therefore not be forced to get involved with the management of the corporation directly. Finally, Maug’s study finds that “a more liquid stock market leads to more monitoring because it allows the investor to cover monitoring costs through informed trading.” (Maug, 1998, p. 88)
In order to set the mechanisms of the market for corporate control in motion, it is necessary that dissatisfied shareholders of the company, who generally do not believe in the efficiency of the company’s management, start to sell their shares. While these shareholders will suffer from considerable losses, even greater capital losses will be prevented by a working market for corporate control, according to Manne (1965, p. 113). Technically, that is through the emergence of bidders for the – by the stock market now down-valued – corporation, who think that they could manage the corporate resources more efficiently. Especially in light of the lackluster performance of other disciplining devices, corporate takeovers on a competitive market for corporate control might be one of the most effective ways for shareholders to get rid of non-value-maximizing managers. (cf. Shleifer & Vishny, 1988, p. 11)
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[1] A discussion of whether this premise can be applied is given in section 5
[2] In an agency problem an agent is entitled to act on behalf of his principal. In a corporate environment, a manager (the agent) is entitled and paid by his shareholders (the principal) that want him to maximize the value of their corporation. As the manager might have different goals or not solely the goal of maximizing profits, he might deviate from the shareholders interest. As the shareholder will not be able to control the behavior of the manager thoroughly, not fully knowing his abilities and goals (asymmetric information is present), the latter has the possibility of deviating from the shareholders interest.