Our latest podcast deep-dives into the recent empirical evidence in relation to corporate investment management (mergers and acquisitions (M&A), capital expenditures (CAPEX), and research and development (R&D) projects).
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This fun podcast is about 10 minutes long (with smart AI podcast generation from Google NotebookLM).
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This review of corporate investment literature focuses on some recent empirical studies of M&A, capital investment, and R&D innovation. This focus spans the empirical evidence in support of the misvaluation and q-theories of takeovers (Dong, Hirshleifer, Richardson, and Teoh, 2006), the effect of anti-takeover provisions on bidder returns around major acquisition announcements (Masulis, Wang, and Xie, 2007), the managerial entrenchment theory for M&A value destruction (Harford, Humphery-Jenner, and Powell, 2012), the complex nexus between CEO overconfidence and corporate investment (Malmendier and Tate, 2005, 2008; Hirshleifer, Low, and Teoh, 2012), and the relation between acquirer-target connections and merger outcomes (Cai and Sevilir, 2012; Ishii and Xuan, 2014). Some subsequent discussion touches on the central theme of stock-market-driven acquisitions in behavioral finance (Shleifer and Vishny, 2003; Baker, Pan, and Wurgler, 2012). The literature review paints several coherent tiles in the complete mosaic of corporate investment management.
Dong, Hirshleifer, Richardson, and Teoh (2006) document evidence in support of the misvaluation and q-theories of takeovers. The misvaluation theory holds that market inefficiency has important effects on takeover activity. These effects stem from the bidder’s efforts to profit by buying undervalued targets for cash at market prices below their fundamental values, or by paying equity for targets that are less over-valued than the bidder (Shleifer and Vishny, 2003). Moreover, the q-theory of takeovers focuses on how acquisitions deploy target assets. High market valuation reflects that a firm is well run with good growth opportunities. Therefore, relative market values are proxies for growth opportunities for both the bidder and the target. Takeovers may be designed to take advantage of better acquirer investment opportunities with minimal wasteful target engagement. Alternatively, takeovers may be viewed by the incumbents of an inefficient bidder as an opportunity to expand their domains of control. Dong, Hirshleifer, Richardson, and Teoh (2006) establish several empirical regularities that bolster both the misvaluation and q-theories of takeovers:
1. Acquirers are highly valued relative to their targets, especially among equity offers and merger bids.
2. More highly valued bidders are more likely to use stock and less likely to use cash as consideration, are willing to pay more relative to target market values, are more inclined to use merger bids in lieu of tender offers, and earn lower returns around merger announcements.
3. Targets with lower market valuation receive higher premia relative to their market prices, are more likely to be hostile to the takeover, are more likely to receive tender offers in lieu of merger bids, are less likely to be successfully acquired, and earn higher returns around acquisition announcements.
Dong, Hirshleifer, Richardson, and Teoh (2006) and Masulis, Wang, and Xie (2007) confirm Loughran and Vijh’s (1997) study of acquirer returns around takeover announcements that stock acquisitions attract negative abnormal bidder returns around merger announcements while cash acquisitions attract positive abnormal bidder returns around merger announcements. Bidder and target market values (price-to-book or price-to-residual-income) significantly correlate with means of payment, mode of acquisition, target premium, target hostility, offer success, and bidder and target returns around takeover announcements.
Masulis, Wang, and Xie (2007) find that excessive managerial entrenchment with takeover defenses has a first-order negative impact on bidder value. Harford, Humphery-Jenner, and Powell (2012) extend this logic and empirically demonstrate that a significant portion of merger value destruction arises from the avoidance of private targets with better ex post managerial entrenchment. When incumbents that receive better insulation from anti-takeover provisions target private firms, these incumbents primarily use cash. This cash payment effectively helps avoid both the potential creation and scrutiny of future blockholders. This rationale also applies to the acquisition of public firms. Incumbents that benefit from more takeover defenses prefer not to use stock when their companies acquire public companies with large blockholders. Nonetheless, target form is not the whole explanation for merger value destruction because on average incumbents that benefit from more takeover defenses make unprofitable acquisitions.
Harford, Humphery-Jenner, and Powell (2012) use the Heckman (1979) sample selection model to affirm that the binary flag for anti-takeover dictatorship has a significantly negative impact on the likelihood of acquiring private targets, acquiring private targets entirely with stock, or acquiring targets with at least 5% blockholder ownership. Harford, Humphery-Jenner, and Powell (2012) apply Officer’s (2007) proxy premium regressions of 5-day cumulative abnormal returns on the binary flag for anti-takeover dictator-ship, the dummy variable for all-stock takeover, the interaction between the dictatorship dummy variable and the proxy premium, and an array of control variables. Ceteris paribus, the dummy variables and the interaction term all carry significantly negative coefficients. This evidence suggests both overpayment and poor target selection as plausible explanations for merger value destruction.
All merger value destruction involves overpayment. Greater managerial entrenchment usually results in worse post-merger operating performance in the Healy-Palepu-Ruback (1992) regressions of industry-adjusted ROAs on the governance or entrenchment index and a set of control variables for the complete sample and different anti-takeover subsamples. This evidence suggests that substandard target selection, rather than only overpayment, explains most merger value destruction. In sum, incumbents that are secure with more takeover defenses often seek to preserve their entrenchment through deliberate target selection.
A body of corporate governance literature suggests a negative nexus between anti-takeover provisions (ATPs) and both firm values and long-term stock returns (Gompers, Ishii, and Metrick, 2003; Bebchuk, Cohen, and Ferrell, 2009). ATPs give rise to higher agency costs through some combination of inefficient investment, lower operational efficiency, and managerial self-dealing behavior. Masulis, Wang, and Xie (2007) directly investigate the impact of a firm’s ATPs on its investment efficiency, or specifically, the shareholder wealth effect of its corporate acquisitions. Acquisition announcements made by firms with more ATPs in place yield significantly lower abnormal bidder returns than acquisition announcements made by firms with fewer ATPs.
Moreover, Masulis, Wang, and Xie (2007) examine the separate impact of external or internal corporate governance mechanisms such as product market competition, board composition such as board size and independence and CEO-chairman duality, as well as operating performance (as a proxy for management quality). Firms that operate in more competitive industries make better acquisitions with larger abnormal bidder returns, as do firms that separate the positions of CEO and chairman of the board.
Masulis, Wang, and Xie (2007) can identify an important channel through which takeover defenses erode shareholder value. ATPs allow corporate incumbents to make unprofitable acquisitions without facing a serious threat of losing corporate control. Masulis, Wang, and Xie (2007) also contribute to the literature on corporate governance by highlighting the importance of the market for corporate control in providing managerial incentives to increase shareholder wealth. This contribution expands the array of corporate governance mechanisms and so pertains to the empirical studies of Bebchuk and Cohen (2005), Cremers and Nair (2005), and Bebchuk, Cohen, and Ferrell (2009).
As the largest and most readily observable form of corporate investment, acquisitions tend to intensify the conflict of interest between corporate incumbents and shareholders in large public corporations (Berle and Means, 1932; Jensen and Meckling, 1976). Incumbents may not always make profitable acquisitions. Often incumbents reap private benefits of control at the detriment of minority shareholders. Incumbents extract large benefits from their empire-building attempts, thus firms with abundant free cash flows but few profitable investment opportunities are more likely to engage in M&A and capital over-investments (Jensen, 1986; Lang, Stulz, and Walking, 1991).
By substantially delaying the takeover process and thereby raising the costs of a hostile acquisition, ATPs reduce the likelihood of a successful takeover and hence the incentives of potential acquirers to launch a bid (e.g. Bebchuk, Coates, and Subramanian (SLR 2002)). ATPs undermine the ability of the market for corporate control to perform its ex post settling-up function. The conflict of interest between incumbents and investors is more severe at firms with more ATPs or firms that are less vulnerable to hostile takeovers.
The IRRC publications cover 24 anti-takeover provisions from which Gompers, Ishii, and Metrick (2003) construct the governance index by adding one point for each provision that enhances managerial power. High G-index firms with more ATPs yield lower long-run stock returns and firm values (Gompers, Ishii, and Metrick, 2003). Bebchuk, Cohen, and Ferrell (2009) extend these results by creating a more parsimo-nious entrenchment index based on the 6 major provisions that are most important from a legal standpoint: staggered boards, poison pills, golden parachutes, supermajority requirements for mergers, and limits to shareholder bylaw amendments and charter amendments.
In the above context, Masulis, Wang, and Xie (2007) deduce the hypothesis of ATP value destruction: incumbents with more ATP insulation are more likely to engage in acquisitions that do not contribute to shareholder wealth maximization. Acquisition announcements made by firms with more ATPs in place produce significantly lower abnormal bidder returns than acquisition announcements made by firms with fewer ATPs. Each additional anti-takeover provision reduces bidder shareholder value by about 0.1%. As a typical dictatorship firm has 10 more ATPs than a typical democracy firm, the former underperforms the latter by about 1%, which is non-trivial relative to the mean cumulative abnormal return around the acquisition announcement of 0.215% (e.g. board classifications correspond to a mean shareholder value loss of $30 million).
Product market competition has a positive disciplinary effect on managerial behavior (Leibenstein, 1966; Hart, 1983; Shleifer and Vishny, 1997). Incumbents of firms that operate in competitive industries are unlikely to divert valuable corporate resources into inefficient uses. In more competitive industries, the margin for error is thin and any missteps can be quickly exploited by competitors. In turn, these missteps jeopardize firms’ prospects for survival. Masulis, Wang, and Xie (2007) use the Herfindahl-Hirschman index as a proxy for industry competition and the industry’s median ratio of selling expenses to sales as a proxy for product uniqueness (Titman and Wessels, 1988). Masulis, Wang, and Xie (2007) document a positive relation between product market competition and bidder return performance.
The board of directors serves as an important internal control mechanism. CEO-chairman duality, board size, and board independence are key characteristics that affect how effectively the board functions (Core, Holthausen, and Larcker, 1999; Hermalin and Weisbach, 2003). Masulis, Wang, and Xie (2007) find a negative nexus between CEO-chairman duality and bidder stock return performance. Separating the CEO and chairman positions helps rein in empire-building attempts by CEOs. As a consequence, these CEOs become more selective in their acquisition decisions that lead to greater shareholder wealth.
Less able CEOs make poor acquisitions and adopt ATPs to entrench themselves. A common practice is to measure bidder CEO quality by industry-adjusted operating income growth over the 3 years prior to the acquisition announcement (Morck, Shleifer, and Vishny, 1990). Masulis, Wang, and Xie (2007) find a positive relationship between bidder management quality and short-run stock return performance. Thus, CEOs of better management quality make better acquisitions in the best interests of shareholders.
Masulis, Wang, and Xie’s (2007) study of short-run abnormal bidder returns reinforces the prior evidence that firms with fewer ATPs generate better long-run shareholder value in comparison to firms with more ATPs (Cremers and Nair, 2005; Core, Guay, and Rusticus, 2005). Overall, Masulis, Wang, and Xie (2007) find empirical support for the hypothesis of ATP value destruction: incumbents with more ATP insulation are more likely to engage in acquisitions that do not contribute to shareholder wealth maximization. In essence, acquisition announcements made by firms with more ATPs in place produce significantly lower abnormal bidder returns than acquisition announcements made by firms with fewer ATPs.
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