Introduction

MERGERS AND TAKEOVERS are two of the most contentious aspects of the functioning of the stock market. They have a key role in corporate governance in that they change corporate ownership and control. Many of them take place in an atmosphere of high drama, since entrenched managers often resist the dangers (to them) of a new ownership structure. By convention, such events are described as "hostile takeovers," but one could easily take the viewpoint of the invading company and call them "hostile defences protecting the incumbent managers who fear being replaced."

Takeovers are initiated by entrepreneurs who seek out firms whose assets are undervalued by the market because the incumbent managers do not utilize them in the most efficient manner. These entrepreneurs, or "corporate raiders," bring to the task a special insight and information which helps them identify new and more profitable opportunities for the target company.

After the takeover, the new owners typically replace the existing managers and revamp the corporate strategy; it may require closing, relocating, or selling off some plants, laying off staff, restructuring managerial responsibilities, and increasing corporate debt. The incumbent managers, of course, resist takeover attempts, even though such resistance might not be in the best interests of shareholders. We discuss the "poison pill" and a range of other devices employed for this purpose.

The measurement of benefits from takeovers is complex. Our interpretation of the U.S. and Canadian literature reviewed in this chapter leads us to conclude that they result in significant net benefits to shareholders and other stakeholders as well. This result is contrary to the popular press view that takeovers are merely the product of power struggles between greedy capitalists.

We pay close attention to the impact of takeovers on minority shareholders and, based on a survey of empirical evidence, express skepticism about the need for regulatory intervention on their behalf. Finally, we discuss the application of a new market instrument - the junk bond - in financing of takeovers. We review its treatment in the popular press as a prime example of one of the tools of the "decade of greed." We paint junk bonds in a more favourable light and highlight their contribution to bringing together people who wish to make mutually beneficial exchanges of securities with high risk and high return.

Hostile takeovers

In theory, the statutory authority of the corporate board of directors, coupled with the ability of shareholders to sell their shares if they find the corporation's performance unsatisfactory, will force managers to act so as to maximize the value of the firm, i.e., the net present value of future profits. When these mechanisms fail, a hostile takeover will take place and will remove managers who ignore shareholder interests. [In practice, many takeovers are not designed to discipline managers. Somewhat ironically, they sometimes enable managers to expand the scope of their control by directing the firm's cash flow into new ventures (Shleifer and Vishny 1988, p. 7).] As Bernstein (1992b, 299) notes, "the stock market is a huge voting booth in which the ballots are counted every minute of the business day."

In a hostile takeover, a "raider" bids for shares of the target firm, i.e., deals directly with the firm's shareholders, rather than with management. When the bidder gains the required votes, it assumes control of the target firm and removes the existing management. In the process, the bidder often increases corporate debt, reduces employment, and sells off parts of the firm. The anticipated increase in profits of the target firm raises its value, and existing shareholders are typically paid a premium of 30 to 50 percent for their shares. Since the bidder deals directly with shareholders, it is able to remove the incumbent managers against their will. However, managers are often offered large separation payments ("golden parachutes") to reduce their opposition against the bid (Shleifer and Vishny, 1988, p. 11).

Hostile takeovers seem to be more frequent in industries subject to decline or rapid change, where managers fail to make the necessary adjustments. For example, in a sample of U.S. Fortune 500 firms, those firms that became takeover targets had a lower ratio of the market value of their debt and equity to replacement cost of physical capital (Tobin's "q") than had other firms in the sample (Shleifer and Vishny, 1988, p. 11). This suggests that corporate raiders seek out firms whose physical, human, and financial assets are not utilized in the best possible manner. By selling off some assets, reducing employment, increasing corporate debt, and replacing incumbent managers, corporate raiders may be able to increase the corporate wealth and the wealth of society as a whole. A part of the increase is transferred from employees, suppliers, and managers to shareholders even where the incumbents were reluctant or unable to do so.

The raider has to bear the transactions costs associated with the bidding process, such as the cost of acquiring information and preparing the bid. In addition, some of the raider's gains from acquisition may have to be shared with the existing shareholders of the target firm. For example, when a hostile takeover bid is initiated, small shareholders of the target firm have an option not to tender their shares and, instead, benefit from the increased profitability resulting from the policies of the new management. Alternatively, they can tender their shares at a price that reflects the anticipated higher profitability, thus depriving the raider of some of the takeover profits. To counteract this strategy, the raider may secretly accumulate some shares on the open market at a price consistent with the valuation of firm reflecting the policies of the old management. [The current U.S. regulations allow the accumulation of only five to 10 percent of shares before the bidder has to make a statement declaring the intention to take over the target firm. For shares traded in Ontario (and much of the rest of Canada), the bidder becomes an insider once ten percent of the shares has been purchased, and must report all subsequent trades (although with a time lag).]

Managers of the target firm employ a variety of devices to protect themselves against hostile takeover bids. The strongest type of defense is the "poison pill." It takes a number of forms, but the common element is imposition of some costs on the bidding firm, for example by forcing it to dilute its equity holdings (by issuing new shares to shareholders other than the raider), revoking or diluting its voting rights (through a pre-determined change in voting powers triggered by the raider's arrival), or forcing it to assume unwanted financial obligations. The poison pill is usually triggered when a tender offer is made, or when a single holder accumulates some specified percentage of shares of the target firm. Managers may also attempt to prevent hostile takeovers by implementing the same measures that would be expected after the takeover, such as taking on more debt or selling off some divisions of the firm. Some of these actions increase the value of the firm, so even the threat of a takeover is potentially good for shareholders. In some cases, managers have been known to modify corporate charters to make a change in control of the firm more difficult, or to lobby for a change in legislation in favour of incumbent management.

Inco is a prime Canadian example of the use of poison pill defence. In late 1988, concerned with a potential takeover, a special shareholders' meeting approved a Recapitalization Plan, consisting of a special cash dividend of $10 per common share and a Shareholder Rights Plan. The cash dividend payment, totalling $1.06 billion, made the company less attractive, while the Shareholder Rights Plan increased the number of shares outstanding in the event that any party acquired 20 percent or more of the voting shares, thus making it more difficult for the raider to succeed. Some shareholders, especially institutional and small investors, unsuccessfully fought this plan through the shareholders' meeting and through the courts, since it protected current management at the expense of minority shareholders who would expect to benefit from a bidding war. [The Globe and Mail, December 10, 1988, p. B1.]

Reasons for takeovers and acquisitions

Acquisitions are probably the most important mechanism through which firms enter new lines of business (Shleifer and Vishny 1988, 13). In deciding which lines of business to enter, managers consider what they have to add to the firm they buy. Their contributions may include technological synergy (the whole is more than the sum of the parts), access to new markets or to capital, and their own managerial talents.

In many of the recent acquisitions of the fledgling biotechnology companies by large multinational drug companies, for example, several of these motives are combined. The biotechnology companies gain access to established marketing networks of the drug companies and to much needed cash flows to finance their R&D. The drug companies, in turn, hope to replenish their stock of innovative ideas and benefit from synergies between the traditional chemistry-based technologies and the emerging processes of biotechnology.

Most takeovers are beneficial, but not all. Managers who plan takeovers may also have their own objectives, for example, a desire to enlarge the size of their firms, to make themselves less replaceable, or to move into faster growing lines of business. The pursuit of some of these objectives does not increase the value of the firm, and, in other words, is not in the interest of the shareholders.

In this sense, Shleifer and Vishny (1988, pp. 14-15) argue that bidders overpay for companies they take over by paying for benefits which are valuable only to managers, but not to shareholders. Shareholders of the target companies benefit and shareholders of the acquiring companies lose by paying for benefits going to the acquiring company's managers. Acquisitions at inflated prices may thus be the most significant deviation from value-maximizing behaviour on the part of managers, at least in the view of Shleifer and Vishny.

Takeovers are initiated because of many factors, among them deregulation of many previously regulated industries, perceived synergies between the activities of the bidder and the target firm, potential economies of scale and scope to be gained from the combined operation, tax advantages from combining a tax loss of one company with a surplus of another, available managerial competence to handle unrelated lines of business, and increasing globalization of markets, which forces businesses to seek a toehold in other countries through takeovers. These are changes that enhance efficiency and add value to the economy.

In recently deregulated industries, different managerial skills and strategies are required than was the case in a tightly regulated and protected environment. Takeovers are a method of putting new management in place. The airline and telecommunications industries come readily to mind as illustrations. Innovations in takeover financing (such as the junk bond), as well as a change in behaviour of the courts and regulatory agencies in the U.S. away from protecting takeover targets have also contributed to increased takeover activity in the 1980s (Jensen, 1988, p. 28; Jarrell et al., 1988, p. 50).

Jensen (1988, pp. 28-29) draws attention to yet another factor - conflict between managers and shareholders over the payout to shareholders of "free cash flow." This is defined as cash flow in excess of that required to fund all projects that are expected to make a profit. If the firm maximizes value for shareholders, such free cash flow should be paid out. However, payment of cash to shareholders reduces the amount of resources controlled by managers, diminishes their power, and potentially subjects them to monitoring by capital markets when the firm needs new capital.

Availability of free cash flow also enables managers to expand the firm beyond the size that maximizes shareholder wealth. Growth, in turn, is associated with increased managerial compensation and opportunities for promotion. Managers can accomplish the growth objective by engaging in acquisitions, rather than by paying out the free cash flow to shareholders. In the process, they are likely to undertake low-benefit or even value-destroying mergers. In some cases, however, the spending of free cash flow on acquisitions is more beneficial than using the funds to finance low-return projects within the firm. This is one of the reasons why the bidding firms may be able to overpay for acquisitions and thus transfer some of the benefits to shareholders of the target firm.

The free cash flow theory of takeovers predicts that the acquiring firms are likely to perform exceptionally well prior to acquisition and, as a result, have free cash flow. The target firms are either those with poor management and poor performance prior to takeover, or those with large free cash flow that they have refused to pay out to shareholders.

Whether it is more beneficial to shareholders in the long run to use the free cash flow for takeovers rather than for dividend payout obviously depends on whether the takeover is a "success." The net benefits and costs of takeovers in general are also empirical questions. We now turn to the difficult question of identifying and measuring these benefits and costs.

The benefits and costs of takeovers

Scope of the debate

The debate between Robinson and Block (1991) illustrates the range of issues raised in the discussion of takeovers. Robinson argues that corporate takeovers are an example of the pursuit of opportunistic objectives, in contrast to the longer-run industrial strategies of economies such as Japan, Germany, and Korea. [Johnson and Neave (1994) explain this behaviour in terms of differential corporate governance models.] He enumerates several social costs of takeovers, including lost jobs, deadweight costs, increased chance of bankruptcy as the bidding company increases its debt, and negative externalities affecting third parties (such as the consequence of a closure of the main industry in a town). Block replies that takeovers lead to more efficiently run companies and that some bankruptcies are inevitable and probably socially good (he gives the example of the whip and bridle maker). Takeovers are a natural extension of the forces of competition, and help to discipline management.

The key question for the ordinary person is whether takeovers improve the efficiency and competitiveness of the economy. People also want to know how takeovers slice the corporate pie between the various "stakeholders" (shareholders of the target firm and shareholders of the bidder firm, managers, employees, et cetera). And, of course, policy questions immediately follow: Should takeover activity be restrained or encouraged? Should the internal mechanisms for safeguarding shareholder interests be strengthened instead (e.g., the boards of directors)? What type of disclosure requirements should the stock exchanges impose on those who buy shares of target companies with a view to eventually taking them over? What, if any, restrictions should be imposed on the method of financing of takeovers (e.g., are "leveraged buyouts" merely a product of unbridled greed, or a major innovation in financial markets)?

All of these issues have been extensively debated in the academic literature and in the business and popular press (where takeovers are usually deemed to be bad). The academic studies of mergers and takeovers fall into two different methodological groups (Tarasofsky and Corvari, 1991, pp. xi-xiii). In the first group are studies in the tradition of financial economics, which work with models of share price determination, typically assuming that share prices fully reflect all relevant publicly available information. In the second are studies in the tradition of industrial organization, which work with accounting data and compare the pre- and post-acquisition performance of firms involved in a takeover. Studies from both traditions conclude that takeovers on balance are good for the economy.

Empirical evidence

From the vantage point of the finance literature tradition, Jensen (1988, pp. 22-23) summarizes the principal research findings on the effects of takeovers as follows.

First, takeovers benefit shareholders of target companies. For the U.S., Jensen (1988, p. 22) estimates that, on average, they obtained premiums exceeding 30 percent, and more recently reached about 50 percent. Jarrell et al. (1988, p. 51) report that the premiums averaged 19 percent in the 1960s, 35 percent in the 1970s, and 30 percent during the period 1980 to 1985.

Second, the shareholders of acquiring companies gained on average about four percent in hostile takeovers and zero in mergers. Jarrell et al. (1988, 53) report the results of a study of 663 successful U.S. tender offers between 1962 and 1985, which estimated the gains at about one to two percent in the immediate period around the public announcement. However, the gains have declined over time and from the 1980s turned into losses for shareholders of the bidding firms. Whether this reflects managerial self-service or just bad decision-making remains to be seen.

Third, gains in economic efficiency resulting from takeovers (that is, an increase in total wealth as distinct from redistribution of resources) increased the total value of the acquired and acquiring companies on average by about eight percent.

Other findings include:

• the conclusion that management actions to prevent takeovers are generally harmful to shareholders
• golden parachutes for top managers do not usually harm shareholders
• the activities of corporate raiders generally benefit shareholders
• in the U.S. at least, mergers and acquisitions have not increased industrial concentration, and
• the gains from takeovers do not come from the creation of monopoly power.

The post-takeover restructuring of the target company typically includes a shift in corporate strategy (e.g. to meet competition or new market conditions), increased use of debt, plant closings, layoffs of managers, staff, and production workers, and reduced compensation. This is in contrast to the pre-takeover situation where managers often find it difficult to abandon major projects, relocate facilities, restructure managerial responsibilities, and close or sell off some facilities. The new top-level managers may find these actions easier because they have a fresh view of the business and no ties with current employees or the community (Jensen, 1988, p. 23). Statistics show that takeover activity is concentrated in slow-growth industries. It has been argued that takeovers are a cheaper and more efficient form of industrial adjustment ("exit" of firms from particular lines of business) than are bankruptcies.

The improvements in efficiency that come with takeovers can be threatened or delayed if the takeover is resisted by the incumbent managers. The various compensation packages ("golden parachutes") that coax managers into letting go without destructively digging in their heels are therefore useful to all concerned. There is evidence, for example, that the announcement of the adoption of severance compensation contracts by a typical firm has the effect of raising its stock price on average by three percent. [Jensen (1988, p. 39) notes, however, that only a portion of this increase is due to the reduction in conflict between managers and shareholders. The other portion may be a market response to the contract as a signal that a takeover bid is likely.] Stock prices go up because investors then expect to see a smooth transition to new management. However, it is in shareholder interest to extend such contracts only to those members of the top management team who play an important role in negotiating and implementing the transfer of control.

Jensen (1988, p. 21) estimates that the merger and acquisition activity in the U.S. during the decade 1977-1986 generated gains to the selling (target) firm shareholders of $346 billion (in 1986 dollars), and an additional $50 billion to the buying (bidding) firm's shareholders. This amounts to about 51 percent of all cash dividends paid to investors in the whole U.S. corporate sector during the same decade.

Takeovers and myopia

Critics argue that the fear of takeover induces managers to take decisions that overvalue current cash flow and undervalue future cash flow (myopic behaviour). The argument is that this is likely to occur when managers have only limited stock holdings in their companies or when they do not understand the determinants of share values, and when their compensation systems encourage them to increase accounting earnings rather than the value of the firm.

While admitting that such instances of myopic managerial behaviour occur, Jensen (1988, pp. 26-27) offers a number of arguments that markets (as opposed to managers) generally do not behave myopically.

First, price-earnings ratios differ among securities. For example, growth stocks and new issues of stocks of startup companies with no earnings derive their value from characteristics other than current earnings. It may be a prospect of discovery of a mineral, as in the case of startup mining companies, or the prospect of discovery of a breakthrough drug, as in the case of the emerging biotechnology companies, most of which spend, on average, around 50 percent of their sales revenues on R&D, but have yet to show a profit. In examples such as these, investors are clearly taking a longer-term perspective.

Second, there is evidence (discussed in the previous chapter) that stock prices respond positively to company announcements of increased expenditures on investment in tangible assets and negatively to announcements of reduced investment expenditures. These announcements signal at best only a potential for earnings in the future, but the stock price reaction indicates that investors have patience and are willing to wait for results.

Third, the "efficient market hypothesis," supported by a large amount of empirical evidence (reviewed in the next chapter), states that current stock prices reflect all currently available public information, not just data on current earnings. If markets were myopic, stock prices would reflect only short-term results, which is not borne out by the evidence.

Fourth, the alleged market myopia has been attributed to increases in the amount of institutional holdings, since institutional investors allegedly put pressure on management to generate high current earnings every quarter. One particular claim is that R&D spending is reduced as a result of the desire to increase current earnings. Some observers have also argued that the frequency of takeovers increases, since institutions are not "loyal shareholders." However, the U.S. evidence, cited by Jensen (1988, p. 27), indicates that increased institutional stock holdings are not associated with increased frequency of takeovers, nor with reduced R&D expenditures. Moreover, firms with high R&D expenditures do not seem more vulnerable to takeovers (which they would be if the market thought that such expenditures were wasteful), and stock prices respond positively to announcements of increased R&D expenditures, again suggesting that investors are sensitive to the long view.

One such study (Bronwyn Hall, 1990) analyzed some 600 acquisitions of U.S. firms and concluded that the acquired firms did not have higher R&D expenditures (in relation to sales) than did firms that were not acquired. There was no evidence that the post-takeover R&D spending was substantially different from pre-takeover performance. Finally, over a long period of time, the total spending on R&D by U.S. industry has been increasing simultaneously with the growth in takeover activity in the economy.

The Canadian evidence could be perhaps better characterized as the absence of any perceptible relationship at all. In table 5, we present data on Canadian Gross Expenditures on R&D (GERD), and Business Expenditures on R&D (BERD), in millions of dollars, for the period 1963-1992. GERD represents the combined R&D spending of business enterprises, federal and provincial governments, universities, and non-profit organizations. BERD is the R&D spending of the business enterprise sector alone. The last three columns in table 5 report the number of mergers and acquisitions taking place in Canada during the same period of time.

To illustrate the nature of the relationship (if any) between the trends in R&D spending and merger activity, we converted the annual BERD expenditures, measured in constant 1986 dollars, into percentage terms, with 1963=100 percent. In figure 9, we plot the results of this calculation together with the growth in the number of mergers, in percentage terms, over the same period. It seems clear that business sector R&D spending has grown fairly steadily over this period, while the number of mergers and acquisitions has fluctuated widely. This suggests that myopia-induced takeovers have not been a problem in Canada.

A simple plot of this nature of course neither proves nor disproves a causal relationship; a more conclusive analysis would require the application of multiple regression technique, and more data than are available. Nevertheless, there is as yet no case for mergers and takeovers being a major contributor to myopic underspending on R&D.

Click here to view Table 5: R&D Spending and Merger Activity in Canada, 1963-1992

Wealth Transfers

Shleifer and Vishny (1988, pp. 15-16) note that corporate efficiency can improve as a result of takeovers, but draw attention to the pervasiveness of wealth transfers in the takeover process. They affect not only the shareholders of both companies, but also employees, suppliers, and managers (i.e., some shareholder gains come from reductions in wages and managerial compensation and as a result of extraction of lower prices from suppliers).

The important point is that the overall wealth in the economy increases as a result of takeovers (i.e., takeovers are not a "zero-sum game" where the gain to one party must mean a loss to another), as explained above. Shleifer and Vishny merely caution that calculations of social gains from mergers, acquisitions, and takeovers cannot rely on information on shareholder returns alone. The impact (positive and negative) on other stakeholders has to be considered as well.

The social benefits of takeovers should be calculated net of their costs, including services of the services of lawyers, investment bankers, and others organizing the transaction. Shleifer and Vishny theorize that takeovers also have consequences in the form of reduced security of long-term employment, which may lead managers to underinvest in firm-specific human capital, undertake fewer long-term projects, and be less loyal to the firm (1988, pp. 17-18). Some of these can be mitigated by explicit contractual arrangements for severance pay. The threat of immediate takeover may also generate panic, disruptions, and waste, leading to management strategies that deviate from the long-term optimum.

In the authors' view, there is a danger that considerations of this type may be used to protect the incumbent managers and ultimately to impose restrictions on takeover initiatives. Accountability of managers to shareholders should be the paramount concern and, as explained in chapter 2, the supervisory powers of the corporate boards of directors and other internal mechanisms for shareholder protection are not sufficient. Takeovers are an indispensable component of the many forms of protection stock markets offer to investors

One step towards minimizing the costs of takeover-related disruptions would be the removal of existing constraints on share ownership by management. Shleifer and Vishny (1988, pp. 18-19) also propose that members of the boards of directors be compensated with stock, which they would be forbidden to sell until they leave the board. Finally, if hostile takeovers facilitate the adjustment of declining industries, mechanisms such as severance pay and provisions to protect labour should be strengthened. In other words, provisions for compensating the losers comprise a more efficient policy than do prohibitions on mergers and acquisitions.

Some takeovers have been motivated by tax advantages, especially the ability of one of the merging firms to reduce its taxes by absorbing the other firm's losses. Another source of tax advantage is the possibility to step-up the basis of the target firm's assets without paying corporate level capital gains. Empirical evidence suggests that tax benefits have only a minor role in explaining merger and takeover activity (Jarrell et al., 1988, p. 56).

Various authors have alleged that the premiums paid by bidders are the result of transfer of wealth from bondholders, since the bonds of an acquiring firm can drop in value if the firm pays cash for a riskier target firm. Evidence shows, however, that on average the holders of convertible bonds (bonds that can be converted by the holder into another asset, usually common stock) in the acquired firm gain from a merger. The markets presumably anticipate that the profitability of the target firm will improve after the takeover, and holders of convertible bonds will be able to participate in the increased profits as their bonds are converted into shares. Holders of nonconvertible bonds in the acquired firm and holders of convertible and nonconvertible bonds in the acquiring firm neither gain nor lose (Jarrell et al., 1988, p. 57).

The "Industrial Organization" perspective

There has been considerable discussion in the literature concerning the extent to which the gains from takeovers are due to the increased market power (domination of the market) by the new (larger) entity. In other words, does one firm try to swallow its rivals in order to become a monopoly? The emerging consensus seems to be that, except in isolated cases, increased market power cannot explain the gains from takeovers (Jarrell et al., 1988, p. 54).

For Scherer (1988, p. 70), the view that takeovers (and the market for corporate control generally) represent a remedy for the problems caused by separation of ownership and control raises some "awkward questions." For example, U.S. industry performed very well during the 1950s and 1960s, even though very few takeovers took place and the separation was firmly in place. Similarly, the economies of Japan, Germany, Switzerland, and France have performed well during the 1980s and 1990s even though hostile takeovers are practically non-existent and stock ownership is often separated from managerial control.

While Scherer's observations are plausible, their validity cannot be verified. The relevant question is whether the performance of the economies on his list would have been even better if the takeover mechanism was in place during the periods studied. It is also impossible to separate, at the level of the whole economy, the influence of takeovers (or their absence) from the many other factors, national and international, affecting the trends in indicators of aggregate economic activity.

An improvement in economic efficiency of the firm after a takeover cannot be readily inferred from the observed stock price increase alone. Studies that considered a period of one to three years after the takeover found that the acquiring firms experienced negative abnormal returns ranging from 5.5 percent to 16 percent. And, in Scherer's view, the wave of conglomerate mergers during the 1960s and 1970s represent a "widespread failure, evidenced in low returns to conglomerate firms' shareholders and extensive divestiture of ill-fitting, poorly managed subsidiaries" (1988, p. 71).

It is well known that stock prices sometimes move in a fashion approximating a random walk. It is therefore possible that a firm can become a merger target not because its managers failed to maximize profits, but because the stock market randomly (and erroneously) set its price too low. As well, any subsequent fall in prices may have more to do with such undervaluation than with the failure of the merger.

Scherer (1988, pp. 74-76) presents the results of a test of two hypotheses related to the efficiency implications of takeovers. One hypothesis suggests that if takeovers are the result of weaknesses of the incumbent management, the target firms should be less profitable than other firms in their industry group. A related hypothesis deals with the consequences of takeovers: once the inefficient management is replaced and other obstacles to efficiency are removed, the post-takeover profitability should be higher than was the pre-takeover profitability.

The test was performed with data from the U.S. Federal Trade Commission, which disaggregates company operations into detailed industry categories, thus making it possible to make well-focused comparisons between the performance of acquired units and non-acquired units of similar size in the same industry. In Scherer's analysis of the two matched groups, the takeover targets had operating income averaging 11.08 percent of assets, while the industry norm for the relevant industry groups was 12.06 percent. The takeover targets thus under-performed the industry norm by about eight percent, suggesting the presence of weaknesses in management before takeover.

Profitability was measured again over a three-year period some nine years after the takeover. The lines of business subject to acquisition through tender offer were 23 percent less profitable than were lines of business not involved in tender offers. Profitability is calculated as a ratio of operating income to assets and the value of assets of acquired companies is typically "written up" to reflect the takeover price. Much of the observed deterioration in post-takeover profitability seems to result from this accounting revaluation. Scherer (1988, p. 76) therefore concludes that "operating performance neither improved nor deteriorated significantly following takeover."

A major recent Canadian study in the industrial organization tradition (Tarasofsky and Corvari, 1991) also reported that Canadian takeovers as a phenomenon do not, on the whole, improve the performance of the affected firms. "Performance" is defined as a composite of profitability (rate of return) and risk (variability of the rate of return). Improvement occurs when the increase in the average rate of return after the takeover is greater than the increase in its variability (this is the return-risk tradeoff again), or if a decline in the rate of return is accompanied by an even greater decline in its variability. Deterioration is defined analogously. This measurement scheme reflects investors' desire for wealth and aversion to risk.

The study focused on Canadian firms that were partially acquired between 1963 and 1983, i.e., whose stock publicly traded both before and after acquisition. For a sample of over one hundred acquired firms, the average pre- and post-takeover performance was about the same. While about forty percent of the takeovers in the sample registered increased post-takeover performance, another forty percent showed a decline, and for twenty percent performance remained roughly the same. Over one-half of takeover targets with inferior pre-takeover performance registered improvement after the takeover. However, only one quarter of firms with superior pre-acquisition performance improved after the takeover (Tarasofsky and Corvari, 1991, pp. 24-25).

Opponents of takeovers sometimes argue that the bidders can offer a premium merely because the target firm is "undervalued" by the markets. The implication is that the management of the target firm should fight the takeover attempts since in the long run it can offer shareholders better returns than the opportunistic bidder. Empirical evidence is not consistent with this hypothesis; when a hostile bid is defeated, the post-defeat value of the target firm typically reverts to the (market-adjusted) level that prevailed before the bid (Jarrell at al., 1988, p. 55).

Mitchell (1991, p. 21) summarizes three studies on takeovers by the U.S. Securities and Exchange Commission. The first study finds that takeovers do discipline inefficient managers; in particular, firms making poor acquisitions are more likely to be takeover targets than firms that make acquisitions that add value. The second study concludes that increased debt burdens from leveraged takeovers force managers to more carefully scrutinize future expansion plans. According to the third study, the stock market crash of 1987 was caused in part by Congressional action to limit takeovers, suggesting that "market participants view takeovers favourably."

The treatment of minority shareholders

What happens when some shareholders of a firm are able to sell their shares at a premium during a takeover while others are left out in the cold? The concerns with fairness and investor confidence raised by Stanley Beck of the Ontario Securities Commission in the context of restricted voting shares (discussed in chapter 2) also apply to the situation of minority shareholders. This is particularly relevant in Canada, with its small number of widely held large firms (see Thain and Leighton, 1991). In the event of a takeover, control blocks may be sold by majority shareholders at a premium, bypassing minority shareholders, who do not share in the gains.

Amoaku-Adu and Smith (1991, p. 80) discuss four red flags that critics of such takeovers have raised:

1.Minority buyout transactions are "insider" bids. (Insiders are shareholders with special position and influence in the company, such as managers or shareholders with large blocks of shares). Insider bids are non-arm's-length transactions and thus there is a potential for self-dealing (doing business with close associates on non-market, favourable terms).

2.Compared to the minority shareholders, insiders may possess superior information about the value of the target company. The insider bidders may use this information asymmetry to their advantage in a takeover bid.

3.Minority shareholders are usually dispersed investors and this weakens their ability to mount any collective action.

4.Unless given special legislative voting power, the collective minority shareholder votes may not be enough to effect a change in corporate policies proposed by the controlling shareholder.

Empirical evidence assembled by Amoaku-Adu and Smith (1991) demonstrates that such concerns are groundless: minority shareholders earned more on Canadian companies taken private over the 1977-1989 period than they did in cases where the purchaser was a non-controlling shareholder. Presumably, the minority shareholders are adept at shifting their investments quickly enough to take advantage of profitable opportunities as they arise. The gains to Canadian shareholders of the target companies are not significantly different from those in the U.S., despite the closer degree of ownership and fewer multiple bids in Canada. This last factor is particularly relevant, since, according to Walkling and Edmister (1985), the existence of an opposing bid increases the size of tender offer premiums (the excess of the bid over the pre-bid market price) in U.S. takeovers.

The role of leveraged buyouts

Few aspects of the securities industry have received as much negative press as leveraged buyouts, particularly those financed by junk bonds. A leveraged buyout (LBO) is a takeover where the new owner (often current management) borrows most of the purchase price. The new owner uses the assets of the target company as collateral for the loan; that is, the buyer tells the lender that the company is worth at least so many dollars, so the lender should feel secure in financing its acquisition. Since the target company typically already has some senior debt in place, the new financing is necessarily junior. [The seniority of debt refers to its place in the pecking order. Senior debt has a prior claim to junior debt.] When the new financing only receives a bond rating of "speculative," which is below investment grade but above default grade, the debt is usually called "junk bonds." [Speculative grade bonds include three types of debt: original issue junk bonds, "fallen angels" (formerly investment grade), and "phoenixes" (formerly default grade). Common usage is to treat junk debt and speculative grade debt as synonymous, but technically this is only proper for original issue junk debt.]

The 1980s have become known as the "decade of greed," symbolized by the insider trading activities of Ivan Boesky and others, and fuelled by the junk bond market created by Michael Milken of Drexel Burnham Lambert. Viewed by many as the collapse of capitalism, when trading of paper replaced the trading of goods, the decade ending with the demise of Boesky, Milken et al. has been likened to a morality play. Kelley and Scott (1993) reject this interpretation. They compare the evolution of finance to technological change in other goods and services during this period, including VCRs, cordless phones, and computerized reservation systems. In their opinion, innovations in finance are just as valuable as new consumer products, and the extensive body of academic research on LBOs and junk bonds presents a picture "diametrically opposed" to the popular view of these phenomena. For example, higher shares of equity owned by management and higher debt levels improve managerial incentives and impose the "discipline of debt". Inefficient and less profitable assets and lines of business are sold off or shut down, bureaucracies are streamlined and excessive costs pared, and more efficient firms emerge.

As an added benefit, junk bonds help to restore the connection between ownership and control (discussed in chapter 2). The dismantling of conglomerates has led to more focused companies. Kelley and Scott cite evidence that LBOs have freed up large amounts of capital, and that shareholders and the economy as a whole has gained from the process. For example, one study estimated that the $1.8 trillion dollars of U.S. corporate control transactions between 1976 and 1990 created over $650 billion of value for selling-firm shareholders (Kelley and Scott, p. 33). The incidence of LBOs financed by junk bonds was important, though not as prevalent as was popularly believed, and only three percent of such financing was used for hostile takeovers, while 22 percent was used for acquisitions in total.

Much of the bad press junk bonds have received relates to their role in aggravating the collapse of the U.S. savings & loans industry, as savings & loans managers sought out increasingly risky investments to service the high rates of interest they were forced to pay to attract investors. For many thrifts, as they are also known, real estate and junk bonds represented a disproportionate percentage of their portfolios, and the dual collapse of both real estate and junk bonds led to their demise. Nobel Prize winning economist Harry Markowitz (1992) sees the problem not in the junk bonds themselves, but rather in a system where risk and reward were separated by inappropriate regulation. The rewards accrued to the thrift managers, but the risks were borne by U.S. taxpayers through deposit insurance for which the premiums did not reflect the riskiness of the investments made by the thrifts. Hence there was little market pressure to constrain the type of investments these institutions made.

Bernstein (1992b, p. 302) concludes that the "junk bond market ... flourished because it satisfied the needs of both the investors who bought junk bonds and the relatively small companies that issued them." In the case of the issuers, who tended to be cut off from bank financing, junk bonds allowed access to new capital without diluting ownership through the selling of new stock. In the case of purchasers seeking higher yield investments, debt security (even junk debt) was preferable to an equity claim in small, unknown companies. Similarly, Markowitz (1992, p. 91) notes that:

Clearly the junk bond market serves a useful purpose in bringing together supply and demand for such higher-risk, therefore higher-yield, securities.

Management buyout as a form of takeover deserves a separate comment. Its benefits include increased managerial incentives, savings on transactions cost due to more concentrated ownership, increased privacy, and tax savings. There is also evidence that the increase in share price during the LBO process benefits public shareholders, so that the gains from restructuring are not all captured by the acquiring management team. Potential negative consequences include the possibility of suboptimal actions to avoid hostile takeovers, potential difficulties in raising new capital, reduction of share liquidity, and the loss of managerial discipline that normally results from the pressure of public shareholders exercised through the stock market (DeAngelo and DeAngelo, 1987). [Briloff (1988) also cites examples of where LBOs can distort traditional accounting statements.]

LBOs have been relatively less common in Canada, probably due in part to the large number of closely held companies (see Thain and Leighton, 1991). There is no evidence to indicate that their effects have been qualitatively any different from those of the U.S. experience. The tentative conclusion here is that LBOs financed by junk bonds are not different from conventional changes in corporate control. Their inherent value must be determined using criteria discussed in chapter 2.

Summary

The last two chapters have reviewed the role of the stock market in corporate governance. This chapter has focused on the market for corporate control, and the many arguments for and against "hostile takeovers."

Viewed from the vantage point of shareholders, takeovers and acquisitions enhance the accountability of managers to shareholders and are an important mechanism through which stock market trading protects investor interests. They are a highly effective method of revitalizing the business strategy of the target companies and improving the value of their assets.

The benefits to shareholders are substantial - some U.S. estimates suggest that the value of gains from mergers and acquisitions during the decade 1977-1986 was about one-half of all cash dividends paid to investors in the whole U.S. corporate sector during the same decade. Contrary to some assertions in the popular press, empirical evidence indicates that increased market dominance (or monopoly power) is not an important source of gains from takeovers.

While most of the shareholder benefits result from improved post-merger performance of the target companies, some of them come at the expense of the incumbent managers and other stakeholders. We have reviewed the various forms of poison pill and other takeover defences employed by managers, and the use of "golden parachutes" and similar arrangements for mediating the conflict between managers and shareholders. In our view, they are preferable to regulatory restrictions on takeovers which may deprive shareholders of potential benefits.

We have examined the evidence on the relationship between mergers and acquisitions on the one hand and corporate investment in long-term growth, exemplified by R&D spending, on the other. In our view, the argument that mergers and takeovers contribute to myopic underspending on R&D does not stand up to close scrutiny.

The last part of the chapter pays considerable attention to leveraged buyout takeovers financed by junk bonds. We view them as a financial innovation that allows access to new capital to investors cut off from bank financing because of the riskiness of their ventures. The evidence indicates that leveraged buyouts and junk bonds may not be as evil as portrayed by the media, and that leveraged buyout takeovers are not qualitatively different from conventional takeovers.