The court of last resort : a reassessment of agency costs in the UK takeover market

Abstract

This thesis examines the role of agency costs in the context of takeover markets, which leads to a better understanding of the functioning of the market for corporate control and takeover likelihood. There has been considerable previous research on the main topics considered here but using new methodologies and techniques, a number of contributions to the literature are identified. The thesis contributes to the literature by (1) reassessing bidding firm abnormal returns, (2) using takeover likelihood to identify a detailed view of the market for corporate control with regards to disciplinary targets on the basis of agency costs and agency costs of free cash flow. In a sample of successful takeover announcements from UK bidders between 1995 and 2014, half of modelled events display ARCH effects. We apply the appropriate GARCH models to correct market model parameters estimated during the market model estimation period. We find that the standard market model overstates betas when ARCH effects exist, in turn leading to an overstatement of negative Cumulative Average Abnormal Return. Significant differences between the market model and GARCH adjusted model are identified. Our results show agency costs to bidding firms, consistent with previous studies. But returns must be somewhat upwards corrected. These differences do not translate to significantly different coefficients in CAR prediction models. Conclusions of such prediction models are thus unaffected by GARCH adjustment. The second empirical chapter tests whether agency costs predict takeover likelihood and if the takeover mechanism disciplines inefficient management. The approach is to identify candidates for disciplinary takeover on the basis of excess return and Tobin’s Q from a sample of companies with primary listing in London between 1986 and 2016. When using the lowest decile for excess return to identify disciplinary targets, takeover risk increased but little evidence was found to indicate that fundamental agency cost indicators were related to takeover risk. The market was more selective regarding companies in the lowest decile of Tobin’s Q. These companies appear undervalued and, therefore, improved managerial efficiency is likely to enhance company value. In the third chapter, the disciplinary candidate identifier is adjusted to detect agency costs of free cash flow. A set of company-year observations with high free cash flows but where growth opportunities for investment of that cash were lacking, was generated. Specifically, we required both Tobin’s Q to exceed, and free cash flow on assets to fall below, industry-year cut-offs at the quartile and the median. However, we only find limited evidence for such companies being disciplined in takeover markets. We did not observe strong evidence for companies’ ability to adjust takeover likelihood by distributing cash to investors. These findings imply that agency costs of free cash flow are regulated through means other than the market for corporate control. The findings presented in this thesis provide a set of implications for researchers, practitioners, as well as regulators and policymakers. For researchers, the evidence in this thesis suggests that ARCH effects should not be ignored when performing event study methodology. When researching the market for corporate control, the cut-off point for excess return and Tobin’s Q must be set relatively low for the classification of the disciplinary set - in our study at around 10% to 20% of the sample. Regarding agency costs of free cash flow, it is not sufficient to use low Tobin’s Q alone and overlook free cash flows. For practitioners, the results on bidding firm abnormal returns demonstrate that previous findings of long-term underperformance must be somewhat upwardly corrected, even though our findings confirm previous studies which show that UK acquisitions do not create value for acquirer shareholders. Through the study of takeover likelihood, a well-functioning market for corporate control is observed in the UK. What is important is the display which companies are likely to be disciplinary candidates. The evidence suggests that agency costs of free cash flow are not a significant determinant of takeover likelihood in the UK market for corporate control. For regulators, the main implication is that an open merger policy is desirable if a functional market for corporate control is expected to protect shareholders from agency costs.