Stefano Rossi and Paolo Volpin, Journal of Financial Economics 74 (2004) 277-304
Introduction
Shareholders hire managers to operate firm assets and return the highest possible cash flows to investors. Clearly, if assets are poorly managed, they will produce lower cash flows than if the assets are utilized effectively. Additionally, cash flows to investors are lower if managers misappropriate funds for their own benefit, when they should distribute the cash flow to investors. Since the value of the firm is the present value of cash flows, the value of the firm (reflected in its stock price) must be lower than its true value when poorly managed. The difference between the value of a firm under effective management and the value under poor management creates an opportunity for an acquiring firm to intercede and buy assets at a price less than their true value. A prospective bidder would be able to pay more than the current share price (but still less than true value) to the target investors and still realize a profit for their own shareholders if the stock price moves closer to its true higher value under the management of the acquiring firm.
Therefore, one function of mergers and acquisitions is to allocate control of corporate assets to the firms who manage them best. Laws and regulations are another avenue for protecting shareholders against value reducing actions of management. Around the world, some countries are less effective in protecting investors against managers who misdirect or misappropriate assets. Also the environment for mergers and acquisitions, which is often called the market for corporate control, is not as active in some countries. This paper studies whether or not country level investor protections relate to merger and acquisition metrics like volume, target and bidder characteristics, premiums paid and method of payment as the described line of thinking would suggest. In line with their story, they find better investor protections do lead to more acquisitions with higher premiums that are more likely to paid in stock. In addition, target countries tend to be in countries with poor investor protections compared to their acquirers, indicating that firms operate under better investor protections after being acquired. Therefore “cross-border M&A activity is an important channel for effective worldwide convergence in corporate governance standards,” and the convergence is toward high standards.
Investor protections and M&A
Investor protection has two important components; it requires both rights of shareholders against managers and reliable enforcement of these laws. If managers are able to misappropriate funds for their own private benefit because of lack of laws or poor enforcement, then maintaining control of the firm is very valuable to management. Therefore, managers will vehemently oppose takeover bids unless there is an extremely high premium. Thus the likelihood of a successful bid and the volume of takeovers will be lower in this case. Many other reasons for deal volume have been researched, but after controlling for these factors, Rossi and Volpin find that deal volume in a country increases with investor protections. Therefore investor protections improve an economy’s ability to optimally allocate control of assets.
In friendly deals, managers may be able to negotiate high termination packages or stay on as managers. However, hostile deals are especially likely to threaten control of assets, in addition, the threat of takeover is believed to have a disciplinary effect on management. Therefore, the frequency of hostile bids, whether successful or not, also is a measure of the effectiveness of the market for corporate control. Similar to deal volume, when investors have better protections, control is more likely to be contestable and the number of hostile deals increases.
When considering cross-border acquisitions, the value of a target firm should be higher to firms from countries with investor protections that are better than the protections in the home country of the target firm. This is true because shareholders in the well protected acquiring country will received higher cash flows than the current shareholders because acquiring managers are more restricted than the current managers. They find that the difference in investor protection does relate to the number of deals observed between two countries. Furthermore, if a country has poor investor protection, then it is more likely to be the target in a cross-border M&A transaction. This is a reasonable hypothesis because the potential for increased value from a change in managerial control increases as the difference between the investor protection in the two countries increases. Consider an example where the world consists of two countires: one with high shareholder protection and one with low protection. Assume both countries have 1 firm and these firms are identical. The managers in both countries operate equally effectively so the firms have a present value of earnings after all expenses of 10 dollars. The managers both want to misappropriate cash flow for their own benefit, but laws in country A limit the amount that managers can “get away with.”
Example
| Country | Investor protection | PV of CF to Managers | PV of CF to Investors |
|---|---|---|---|
| A | High | 1 | 9 |
| B | Low | 3 | 7 |
The firm’s share price should exactly be the present value of the cash flows to investors. If shareholders in country A could recognize that the firm in country B is selling below its true value, they would be willing to pay up to 9 dollars to acquire the cash flows of the firm in country B. In other words, they would be willing to pay a premium of up to 2 dollars to acquire the firm in country B. The shareholders in country B would agree to a tender offer at some price greater than 7 dollars. On the other hand shareholders from country B would only be willing to pay 7 dollars for firm A assets, which is less than the current share price. Therefore shareholders in country A would not accept this deal. This illustrates why acquirers in cross-border deals will come from countries with higher investor protections than the countries where the target firms are located. This is the convergence result, the market for corporate control has facilitated the convergence of corporate governance because firm’s from countries with strong protections acquire firm’s from countries with poor protections. As the acquiring firms subject the target firm to the higher governance standards, global governance converges to that of the good investor protection countries. In addition this example demonstrates that higher investor protections in an acquiring firm also relate to higher premiums.
Finally, investor protections also can predict the method of payment used in deals. If the acquiring firm is from a country with poor investor protections, targets are less willing to accept stock as payment. This finding is consistent with the idea that target shareholders are concerned that the managers in the acquiring firm will misappropriate the cash flows of the combined firm and subsequently the target shareholders receive lower cash flows. Therefore, when an acquiring firm is from a country with low investor protections the target shareholders demand the more certain cash payment. Similarly, if the acquiring firm is from a country with good investor protection, the deal is more likely to consist of stock.
Thus, in conclusion, high country level investor protections do relate to high merger and acquisition metrics of competiveness and effectiveness. In addition, cross-border M&A activity enables convergence to high corporate governance standards.