Takeovers, Governance and the Cross-Section of Returns

Abstract

This paper considers the impact of the takeover channel on firm valuation. We usethe idea that takeover activity responds to investor expectations of future rate of return and hence to state variable(s) related to the time variation in risk premia. Thus firms with higher exposure to takeovers, due to higher expectations of receiving a takeover premium, have a higher exposure to the state variable that dictates time variation in risk premia. Consequently, the difference in the returns between firms that differ in their takeover vulnerabilities can be used to used to proxy these state variables. To do so, we create a takeover-spread portfolio that buys firms with low cash-adjusted-leverage(cheaper targets) and shorts firms with high cash-adjusted-leverage and show that sucha portfolio generates annualized abnormal returns of up to 11.20% between 1980 and2003. Also, abnormal returns associated with governance-spread portfolios (Gompers,Ishii and Metrick, 2003 and Cremers and Nair, 2004) decrease significantly once the assetpricing model includes this cash-adjusted-leverage factor. Finally, we propose a new takeover factor to proxy for the risk due to changes in these risk-premia related state variables, which is shown to be important in explaining cross-sectional differences in equity returns. The paper shows why investors require a higher rate of return on firms exposed to takeovers and yet value them higher than firms protected from takeovers.