Inefficient Results in the Market for Corporate Control: Highest Bidders, Highest-Value Users and Socially-Optimal Owners
Robert T. Miller
University of Iowa College of Law; New York University - School of Law, Classical Liberal Institute
December 18, 2013
U Iowa Legal Studies Research Paper No. 12-22
Legal and economic scholarship on the market for corporate control has generally assumed that if the party willing to pay the highest price purchases the target company, the result will be efficient. This article shows that this invisible-hand assumption, which is generally correct in other markets, fails in the market for corporate control. In particular, whenever multiple strategic bidders compete to buy a target, the highest-bidder, the highest-value user, and the socially-optimal owner need not be, and often will not be, one and the same party.
A strategic bidder will value the target at an amount equal to the present value of the incremental future profits that owning the target will produce. Bidders will thus bid up to this amount to purchase the target, with the bidder having the highest such valuation being the highest-value user of the target. But strategic bidders competing against each other to buy the target generally also already compete against each other in their product markets, and so when one strategic bidder acquires the target, others will usually incur significant costs because the winner can exploit the competitive advantage that ownership of the target confers in ways that will reduce the future profits of losing bidders (for example, by stealing market share from the losers or lowering prices in the product market and so compressing the losers’ profit margins). Transactions in the market for corporate control thus tend to produce significant negative externalities for losing strategic bidders. These externalities are merely pecuniary, however, because they are necessarily balanced by benefits received by the winning bidder or by customers in product markets, and so they are irrelevant to efficiency. Nevertheless, bidders will pay dollar-for-dollar to avoid suffering such externalities. A strategic bidder will thus increase its bid up to the sum of its valuation of the target plus the externality that it expects to suffer from losing the bidding contest. Thus, the highest bidder will be not the party with the greatest valuation of the target, but the party for whom the sum of its valuation of the target, plus the pecuniary externality it expects to suffer from losing the bidding contest, is greatest. The highest bidder will thus not necessarily be the highest-value user.
Furthermore, when the successful bidder uses the target’s assets in its business, it generally creates benefits for customers in its product markets by, for example, reducing prices or improving the quality of goods. Thus, transactions in the market for corporate control also generally produce significant positive externalities. These are real benefits and not mere pecuniary ones, and they are thus relevant to an efficient allocation of the target. But since these benefits are captured by customers in the product markets and not by the successful bidder, bidders will not impound their value into their bids. The socially-optimal owner of the assets will thus be the bidder for whom its valuation of the target, plus the positive externalities captured by customers (net of negative externalities), is greatest. This party need not be either the highest-value user or the highest-bidder.
When strategic buyers compete to buy a target company, therefore, the prices they offer will be distorted both upwards (because they impound negative pecuniary externalities bidders will suffer from losing the bidding contest) and downwards (because they do not impound positive real externalities to be captured by customers). Since there are multiple potential strategic buyers for the great majority of target companies, such distortions are common in the market for corporate control. Moreover, as constructed but plausible examples show, the distortions can often be very large relative to the market capitalization of the target.
These results imply that the well-known empirical findings that strategic acquirers tend to overpay for targets can be explained on neo-classical grounds without necessarily resorting to agency theories or behavioral economics, classical auction theory, which assumes that bidders set their bids without regard to the identity of other bidders, does not apply to the market for corporate control, and inefficiencies caused by antitakeover devices and deal protection devices, while real, are less important than previously believed because distortions arising from such devices will usually be significantly smaller than the distortions identified in this article. The article concludes by considering and rejecting the possibility that a regulatory agency could correct the inefficiencies identified.
Number of Pages in PDF File: 58
Keywords: corporate control, efficiency, mergers
Date posted: October 4, 2012 ; Last revised: December 19, 2013