High Yield Financing and Efficiency-Enhancing Takeovers

Abstract

This study analyzes the determinants of the risk of takeover from 1981 to 1997 based on a sample of 896 Fortune 500 firms using sophisticated methodology. The measure of firm efficiency includes both production costs and overhead expenses. If relatively inefficient firms are chosen as the targets in takeovers and the new owners reduce the costs of these inefficiencies, then the potential for gains from takeovers for the US economy exists. Because firm-level costs are adjusted for the industry median, the study is able to capture the inefficiency implications of firms where it is clear that other firms in the same general product line are better controlling their costs. Indeed, high total cost per unit of revenue is a powerful determinant of the risk of takeover throughout the period under study. The impact of size on the risk of takeover, however, changed across time.

When financing was readily available, in particular during the period of the early 1980s, larger firms actually faced a higher risk of takeover. Since both costs and size are measured in terms of revenue, one can easily see that the cost savings associated with the takeover of a larger firm might result in larger dollar savings. Unfortunately, our analysis shows that regulatory actions against takeover financing changed this. Distinct from other active takeover periods, that of the 1980s was characterized by the use of high yield financing. Beginning in 1983, almost coincidental to the announcement of the first large takeover attempt financed completely with high yield debt, a bill was introduced in the US Congress to eliminate the tax deduction for all debt used in takeovers. By the time of its passage in 1989, the bill was directed at only high yield financing.

After that, size began to have a strong negative effect on the risk of takeover. By 1990, once a firm reached a certain size threshold, being inefficient relative to other firms in its industry was no longer sufficient to put it at risk for takeover. This policy brief demonstrates how these and other regulatory changes established a size-efficiency tradeoff by which the risk of takeover decreased with size for larger, relatively inefficient firms in the late 1980s. This finding has serious implications for the efficiency enhancement gains available from takeovers after regulations were enforced against the use of high yield securities for financing corporate control activity.

Keywords: Takeovers, mergers, targets, "junk bonds", high-yield bonds, corporate governance,regulation

JEL Classification: G3, G34, C2, C23, C24