A Theory of Preemptive Entrenchment

Abstract

Entrenchment can benefit shareholders since aggressive managers deter rivals and, thus, make competition softer in the product market. I formalize this intuition within a simple industry equilibrium model of optimal entrenchment and test its implications empirically. The key cross-sectional prediction of the model is that industry leaders benefit most from preemptive entrenchment, since they suffer relatively larger losses in market share from facing tougher competition. I find strong support for this prediction and a number of related cross-sectional implications of my model using a large sample of U.S. public firms between 1990 and 2005 and a wide variety of entrenchment measures, such as external (antitakeover provisions, state antitakeover laws) and internal (board size and independence, institutional shareholders and pension funds) governance. In particular, I find that (i) industry leaders are more entrenched than laggards; (ii) the valuation effect of entrenchment is negative for laggards, but positive for leaders. Moreover, the link between industry leadership and the valuation effect of entrenchment is more pronounced in industries that are more concentrated, relatively less heterogeneous, and less subject to foreign competition. These findings offer a novel perspective over the debate on whether governance creates value by documenting when that is actually the case.