Takeovers as Market Discipline for Managers

Moral hazard problem between managers and owners, particularly when managers have small equity shares of firms.

Mechanisms that align incentives:

Market for corporate control:

Prospective managers recruit owners (existing shareholders, venture capitalists, bond holders, etc.) and compete for the right to control assets.

This may provide managers better incentives than internal controls (Alchian and Demsetz: who will monitor the monitor)

Why might internal controls work badly?

This theory was of particular interest given the wave of M&A/hostile takeover/LBO activity in the 1980s.

Although there were a number of well-publicized takeovers, these hostile takeovers were a small percentage of the acquisitions.

Publicity may have arisen because of the unprecedented size of the transactions, which was facilitated by the invention of new financial instruments such as junk bonds.  Before the 1980s, managers of extremely large firms may have been insulated from this form of market discipline.

Moral hazard as applied to firms' managers.

Managers will tend to make decisions that maximize their own utility.  These are not necessarily value maximizing.

What incentives does market for corporate control provide managers?

Incentives in the market for corporate control

However, markets for managers should discipline these individuals and punish hubris and moral hazard

They also provide incentives to acquire information so as to avoid the winner's curse.

Managers can mitigate moral hazard problems by financing with debt -- promises to return cash to owners (debtholders) rather than investing in other projects.

(Recall that there are agency costs of debt as well, so there is a tradeoff.)

Efficiency explanation of high debt levels in hostile takeovers: LBOs.  Guards against free cash flow problems.

Incentives for incumbent shareholders

Hold out!

But if this is the case, why would any prospective owner bid at all if there are no gains?

Solution: secretly acquire shares before announcing takeover bid, gain on increase in share price.

Legal constraint: Disclosure required for acquisition of >5% of a firm's shares within 10 days.

Too few takeovers?

General predictions of theory.

Empirical evidence

Assuming that the stock price reflects companies' true value...these are largely borne out by the facts, if a small window (one month) is used for evaluation.


Takeovers in 60's and 70's did not appear to increase value, although they were conglomerations rather than the "bust up" takeovers that took place in the 1980s.

Good book: Barbarians at the Gate -- the story of KKR's takeover of RJR Nabisco.

Good project: analyze incentives within takeover in light of economic theory.