Mergers and Acquisitions; P. Klein

name: the "Decade of Greed." Pundits and politicians, and even some professors, charged that these corporate restructurings did little but shuffle assets on paper, lining the pockets of clever financiers at the expense of workers and the average Dr. Klein is Assistant Professor of Economics at the University of Georgia, and an Adjunct Scholar of the Ludwig von Mises Institute. shareholder. The critics invented anew, coloITul language to describe the proceed ings: takeover specialists were "raiders"; high-yield bonds became "junk bonds"; tender offers resisted by incumbent man agement were deemed "hostile takeovers." Popular books like Bryan Burrough and John Helyar's Barbarians at the Gate (on the RJR-Nabisco deal) and James Stewart's Den of Thieves became best sellers. In Oliver Stone's Wall Street, the finan cier Gordon Gecko (played by Michael Dou glas) summarizes the ethical philosophy of the raiders with the famous words: "Greed is good." This, we are told, was the spirit of the times. And the bigger the deal, the harder the criticism. The RJR buy-out is the one "people regard as the most symptom atic of the excesses on Wall Street," ac cording to one more sober account. It was "the culmination of a process that had gone badly out of control. ,,1 Not surprisingly, the truth about mergers and acquisitions is very different from what is portrayed in these accounts. Takeovers, LBOs, and other reorganizations are simply changes in the ownership of assets. As such, they serve an important social purpose; indeed, they are essential to the smooth operation of a market economy. When pro ductive assets are privately owned and traded, these assets will tend to move to ward their highest valued uses. Changes in the ownership of corporations, then, arejust part of the market process of adjusting the structure of production to meet consumer wants. Resources are shifted from owners whose stewardship is poor to those the market believes can do a better job.

Corporate takeovers are an important part of this process. When a firm wants to expand, it can either increase its existing operations or acquire another firm. It will choose the latter if it believes it can buy and redeploy the assets of an existing firm more cheaply than it can purchase new capital equipment. In this sense, a merger or takeover is a response to a valuation discrepancy: acqui sition occurs when the value of an existing firm's assets is greater to an outside party 564 than to its current owners. This differencein valuation may be because the buying firm believes its management or a new manage ment team it installs can operate the target firm more effectively than the target firm's incumbent management. Hence we can also think of mergers as a kind of monitoring institution: takeover, or the threat thereof, serves to discipline managers. If they fail to maintain the market value of the firm, new owners willquickly arrive and replace them.

The Disciplinary Role of Takeovers Since Adolph Berle and Gardiner Means published their 1932 book The Modern Cor poration and Private Property, critics of the corporation have increasingly maintained that because the large modern firm is run not by its owners (the shareholders) but by salaried managers, these firms will not be run efficiently. Shareholders want the firm to maximize its profits, but the managers dislike hard work and prefer other things, like executive perks, prestige, paid vaca tions, and similar rewards. Because of this "separation of ownership and control" what economists now call a principal-agent problem-managers will pursue their own goals at the expense of profits. Since the average stockholder owns few shares in any given firm, no owner will have sufficient incentive to engage in (costly) monitoring of these managers or to take action to replace them. The Berle-Means thesis im plies that advanced market economies must be inefficient, even by the market's own standard of profit maximization.

Henry Manne, then a young law professor and now Dean of the Law School at George Mason University, addressed the Berle Means thesis in a seminal 1965 article, "Mergers and the Market for Corporate Control. ,,2 Manne argued that managerial discretion will be limited as long as there exists an active market for control of cor porations. When managers pursue their own goals at the expense of profit maximization, the share price of the firm falls. This invites takeover and subsequent replacement of 565 incumbent management. Hence while man agers may indeed hold considerable auton omy over the day-to-day operations of the firm, the stock market places strict limits on their behavior. 3 Interestingly, the Austrian economist Ludwig von Mises had expressed the same basic insight sixteen years earlier, in his great work Human Action. 4 In a passage distinguishing what Mises calls "profit man agement" from "bureaucratic manage ment, " he pointed out that despite the importance of the salaried manager in mod ern business life, the shareholders make the ultimate decisions about allocating re sources to the firm in their decisions to buy and sell stock: [The Berle-Means] doctrine disregards en tirely the role that the capital and money market, the stock and bond exchange, which a pertinent idiom simply calls the "market,"

plays in the direction of corporate ·busi ness.... The changes in the prices of com mon and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation's business; it creates a state of affairs to which the managers must adjust their operations in detail.5 Mises does not identifythe takeover mechnism per se as a means for capitalists to exercise control-takeovers were less pop ular before the late 1950s, when the tender offerbegan to replace the more cumbersome proxy contest as the acquisition method of choice-but his point is clear. The heart of a market system is not the consumer-goods market, the labor market, or even the mar ket for managers. Instead, it is the capital marke t, where entrepreneurial judgments are exercised and decisions carried out.

Are Mergers Efficient? Mergers and acquisitions, like other busi ness practices that do not conform to text book models of "perfect competition," have long been viewed with suspicion by 566 THE FREEMAN • SEPTEMBER 1985 antitrust and regulatory authorities. The problem is that the notion of perfect com petition is a hugely inappropriate guide to public policy. In the real world of uncer tainty, error, and constant change, "effi ciency" means nothing other than direct ing resources toward higher-valued uses. This can only be measured by the successes and failures of firms as determined by the market. What is good for the firm, then, is good for the consumer. Any merger that is not known to be a response to legal restric tions or incentives must be assumed to create value. At the same time, several studies have found a sharp divergence between market participants' pre-merger expectations about the post-merger performance of merging firms, and the firms' actual performance rates. David Ravenscraft and F. M. Scher er's·(1987) large-scale study of manufactur ing firms, for example, found that while the share prices of merging firms did on average rise with the announcement of the proposed restructuring, post-merger profit rates were unimpressive. Indeed, they find that nearly one-third of all acquisitions dur ing the 1960s and 1970s were eventually divested. 6 Ravenscraft and Scherer con clude that mergers typically promote man agerial "empire building" rather than effi ciency, and they support increased restrictions on takeover activity. Michael Jensen, founder of the Journal ofFinancial Economics, suggests changes in the tax code to favor dividends and share repur chases over direct reinvestment, thus lim iting managers' ability to channel "free cash flow" into unproductive acquisitions. 7 Public Policy and the Stock Market But the fact that some mergers-indeed, many mergers, takeovers, and reorganiza tions-turn out to be unprofitable does not imply "market failure" or prescribe any policy response. Errors willalways be made in a world of uncertainty. Even the financial markets, which aggregate the collective wis dom of the entrepreneurs, capitalists, and speculators who are the very basis of a market economy, will sometimes make the wrong judgment on a particular business transaction. Sometimes the market will re ward, in advance, a proposed restructuring that has no efficiency rationale. But this is due not to capital market failure, but to imperfect knowledge. Final judgments about success and failure can be made only after the fact, as the market process plays itself out.8 Certainly, there is no reason to believe that courts or regulatory authorities can make better judgments than the financial markets. The decisions of courts and gov ernment agencies will in fact tend to be far worse: unlike market participants, judges and bureaucrats pursue a variety of private agendas, unrelated to the desires of market participants. Furthermore, the market is quick to penalize error as it is discovered; no hearings, committees, or fact-finding com missions are required. In short, that busi ness often fails is surprising only to those committed to textbook models of competi tion in which the very notion of "failure" is defined away. Such models are surely no guide to public policy. D 1. Sarah Bartlett, The Money Machine (New York: Wagner Books, 1991), p. 237.

2. Henry G. Manne, "Mergers and the Market for Corpo rate Control," Journal of Political Economy 73 (April 1965), pp.110-20. 3. There are other mechanisms to limit managers' discre tionary activities, such as the market for managers itself. On this see Eugene F. Fama, "Agency Problems and the Theory of the Firm," Journal ofPolitical Economy 88 (April 1980),pp. 288-307. This article, along with Manne's and several other important papers on this topic, are collected in Louis Putter man, ed., The Economic Nature of the Firm: A Reader (Cambridge: Cambridge University Press, 1986). 4. Ludwig von Mises, Human Action: A Treatise on Economics (New Haven, Conn.: Yale University Press, 1949; third revised edition, Chicago: Henry Regnery, 1966). 5. Ibid., pp. 306-07. 6. David Ravenscraft and F. M. Scherer, Mergers, Sell Ojfs, and Economic Efficiency (Washington, D.C.: Brookings Institution, 1987).

7. Michael C. Jensen, "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review 76 (May 1986), pp. 323-29. 8. Paradoxically, some critics also charge that unregulated financial markets engage in too few takeovers, due to a "free-rider" problem associated with tender offers. Even when an acquiring firm makes an attractive offer to the target firm's shareholders, asking them to "tender" their shares for a substantial premium over the current share price, some share holders willrefuse to selltheir shares, anticipating further share price increases accompanying a bidding war. These critics conclude that regulation, not the takeover market, should be used to discipline incumbent managers.