How Effective Are Takeovers in Enhancing Dynamism of the U.S. Economy? Roman Frydman Department of Economics, New York University Center on Capitalism and Society, Columbia University

Importance of Corporate Governance Berle and Means: Separation of ownership and control may lead to inefficient allocation of resources. Berle and Means: Separation of ownership and control may lead to inefficient allocation of resources. Corporate governance arrangements: supposed to align the incentives of corporate managers with the owners. Corporate governance arrangements: supposed to align the incentives of corporate managers with the owners.

Corporate Governance Arrangements Internal: board of directors, structure of managerial compensation Internal: board of directors, structure of managerial compensation Market-based: stock prices, takeovers Market-based: stock prices, takeovers

Focus of Extant Analyses of Corporate Governance Design and effectiveness of incentives to enhance static efficiency Design and effectiveness of incentives to enhance static efficiency limiting managerial malfeasance limiting managerial malfeasance motivating managers to maximize profits or minimize costs for a given technology motivating managers to maximize profits or minimize costs for a given technology

Key Distinction Largely Neglected in Studies of Corporate Governance Corporate governance to enhance effectiveness of routine activities Corporate governance to enhance effectiveness of routine activitiesvs. Corporate governance to stimulate entrepreneurial activities involving Knightian (non-probabilistic) uncertainty Corporate governance to stimulate entrepreneurial activities involving Knightian (non-probabilistic) uncertainty development of new innovative technologies development of new innovative technologies

Conflicting Results of Earlier Studies of Takeovers Ignored distinction between takeovers Ignored distinction between takeovers as primarily motivated by routine objectives as primarily motivated by routine objectives as primarily motivated by entrepreneurial considerations as primarily motivated by entrepreneurial considerations Statistical techniques did not allow the profile of takeover risk to vary over time Statistical techniques did not allow the profile of takeover risk to vary over time

Our Results Focus on the distinction between takeovers primarily motivated by routine vs. entrepreneurial considerations. Focus on the distinction between takeovers primarily motivated by routine vs. entrepreneurial considerations. Statistical methodology allows for time- varying risk profile. Statistical methodology allows for time- varying risk profile.

References DISTINCTION BETWEEN ROUTINE AND ENTREPRENEURIAL EFFECTS OF PRIVATE OWNERSHIP: R. Frydman, Ch. Gray, M. Hessel, and A. Rapaczynski, "When Does Privatization Work? The Impact of Private Ownership on Corporate Performance in Transition Economies," The Quarterly Journal of Economics, 1999, R. Frydman, Ch. Gray, M. Hessel, and A. Rapaczynski, "When Does Privatization Work? The Impact of Private Ownership on Corporate Performance in Transition Economies," The Quarterly Journal of Economics, 1999, R. Frydman, M., Hessel, and A. Rapaczynski, “Why Ownership Matters? Entrepreneurship and the Restructuring of Enterprises in Central Europe,” in Fox, M. and M. Heller (eds.), Corporate Governance Lessons from Transition Economies, Princeton University Press, R. Frydman, M., Hessel, and A. Rapaczynski, “Why Ownership Matters? Entrepreneurship and the Restructuring of Enterprises in Central Europe,” in Fox, M. and M. Heller (eds.), Corporate Governance Lessons from Transition Economies, Princeton University Press, DISTINCTION BETWEEN ROUTINE AND ENTREPRENEURIAL CONSIDERATIONS IN TAKEOVERS: S. Trimbath, H. Frydman and R. Frydman “Cost Inefficiency, Size of Firms and Takeovers” Review of Quantitative Finance and Accounting, 2001, S. Trimbath, H. Frydman and R. Frydman “Cost Inefficiency, Size of Firms and Takeovers” Review of Quantitative Finance and Accounting, 2001, H. Frydman, R. Frydman and S. Trimbath, “Financial Buyers in Takeovers: Focus on Cost Efficiency”, Managerial Finance, 2002, H. Frydman, R. Frydman and S. Trimbath, “Financial Buyers in Takeovers: Focus on Cost Efficiency”, Managerial Finance, 2002, S. Trimbath, Mergers and Efficiency: Changes Across Time, Kluwer Academic Press, S. Trimbath, Mergers and Efficiency: Changes Across Time, Kluwer Academic Press, 2002.

The Data Takeovers: control of one firm is subsumed by another; market-driven corporate governance mechanism Takeovers: control of one firm is subsumed by another; market-driven corporate governance mechanism Fortune : 318 takeover targets among 938 firms Fortune : 318 takeover targets among 938 firms Accounting Data: revenue, costs, Tobin’s Q, profitability Accounting Data: revenue, costs, Tobin’s Q, profitability Adjusted to industry median Adjusted to industry median

Determinants of Takeovers Relatively cost-inefficient firms are chosen as targets. Relatively cost-inefficient firms are chosen as targets. No consistent results for other measures of performance. No consistent results for other measures of performance.

Targets are cost-inefficient relatively to non-targets Relative to industry median; statistically significantly different

Post-takeover Changes in Performance  Significant improvements in static efficiency for combined firms (as measured by cost/unit of revenue). Gains are temporally stable. Gains are temporally stable. Examination of other performance measures, such as profit and market value, did not yield consistent results. Examination of other performance measures, such as profit and market value, did not yield consistent results.

Conclusions Takeovers primarily motivated by routine considerations, such as relative cost- inefficiency of the target firms. Takeovers primarily motivated by routine considerations, such as relative cost- inefficiency of the target firms. Takeovers appear to be effective in correcting this failure of internal mechanisms of corporate governance (that is, inability of corporate boards to make managerial decisions cost efficient). Takeovers appear to be effective in correcting this failure of internal mechanisms of corporate governance (that is, inability of corporate boards to make managerial decisions cost efficient).

Takeovers and Entrepreneurs No evidence that takeovers are motivated by entrepreneurial considerations involving Knightian uncertainty. No evidence that takeovers are motivated by entrepreneurial considerations involving Knightian uncertainty. Nevertheless, takeovers may facilitate the relatively more routine adaptation by the corporate sector of new technologies developed by entrepreneurs Nevertheless, takeovers may facilitate the relatively more routine adaptation by the corporate sector of new technologies developed by entrepreneurs

Some Evidence G. Andreade, M., Mitchell, M. and E. Stafford, “New Evidence and Perspectives on Mergers,” The Journal of Economic Perspectives, Takeovers occur in industry waves. Takeovers occur in industry waves.

R. Veugelers, “M&A and Innovation: a Literature Review,” In B. Cassiman and M.Colombo (eds), Mergers and Acquisitions: The Innovation Impact, Edward Elgar Cheltenham, 2006, 37 – 62. Gantumur, T. and A. Stephan, “Mergers & Acquistions and Innovation Performance in Telecommunications Industry,” 2007, Working Paper, Humbolt University, Berlin.   Some within-industry takeovers seem motivated by the desire to adopt a superior technology developed by a more entrepreneurial firm Success in innovation activity increases the likelihood of involvement in a takeover Combined firms have some success in adopting the innovative technology developed by the entrepreneurial firm involved in a takeover.

Basic Sources of Dynamism? Managerial compensation: particularly, ownership-based incentives, such as stock-options. Managerial compensation: particularly, ownership-based incentives, such as stock-options. Potential tradeoffs between external controls stipulated in the post-Enron scandal public debate/legislation and management entrepreneurial initiative Potential tradeoffs between external controls stipulated in the post-Enron scandal public debate/legislation and management entrepreneurial initiative Entrepreneurship and creation of new firms Entrepreneurship and creation of new firms Selection and financing of new ventures Selection and financing of new ventures Labor market and systemic features: security versus insecurity? Labor market and systemic features: security versus insecurity? Culture? Culture?