Which Takeover Targets Overinvest?

Abstract

Existing research finds little evidence of overinvestment by successfully acquired targets. This paper shows how samples drawn from completed takeovers are biased against finding overinvestment and documents evidence of overinvestment in targets that use a highly lever? aged transaction to avoid a takeover. The evidence also suggests that these restructurings create value by mitigating the targets' overinvestment problems. I. Introduction Jensen's (1986) free cash flow theory implies that some firms become takeover targets because their managers inefficiently allocate free cash flow to unprofitable investments. Empirical studies of completed takeovers by Morck, Shleifer, and Vishny (1988), Bhagat, Shleifer, and Vishny (1990), and Servaes (1994), among others, however, do not support this prediction. Nonetheless, these studies do not mean that free cash flow is unimportant in the market for corporate control. Both Jensen (1986) and Stulz (1990) suggest the threat of a disciplinary takeover can prompt firms to curtail overinvestment of free cash flow. Therefore, the absence of overinvestment in successfully acquired firms does not rule out the possibility that this problem characterizes many takeover targets. It is plausible that the threat of takeover systematically leads overinvesting firms to reduce investment. In this paper, I examine firms that use leveraged restructurings to thwart takeover attempts. Jensen (1986), (1989) argues that increased leverage bonds managers to pay out their excess cash flow instead of overinvesting. I begin with a simple model to show how takeover bids can lead to leveraged restructurings. This model suggests that successful acquisitions will be associated with bidder, but not target, overinvestment. The intuition is simple: a leveraged restructuring commits a firm to paying out its excess cash flow, eliminating the need for a disciplinary takeover. To the extent that these restructurings defeat takeover attempts, studies *Leavey School of Business, Santa Clara University, Santa Clara, CA 95053. An earlier version of this paper was titled, What Role Does Overinvestment Play in the Market for Corporate Control? I am grateful to Rene Stulz, David Mayers, John Persons, and Ralph Walkling for their helpful guidance. Thanks are also due to Jonathan Karpoff (the editor), Henri Servaes (the referee), Yaron Brook, Patric