The Free Cash Flow Theory of Takeovers: A Financial Perspective on Mergers and Acquisitions and the Economy

Michael C. Jensen

Social Science Electronic Publishing (SSEP), Inc.; Harvard Business School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

«The Merger Boom», Proceedings of a Conference sponsored by Federal Reserve Bank of Boston, pp. 102-143, October 1987

Abstract:

Through dozens of studies, economists have accumulated considerable evidence and knowledge on the effects of the takeover market. Most of the earlier work is well summarized elsewhere (Jensen and Ruback (1983); Jensen (1984); Jarrell, Brickley and Netter (1988)). Here, I focus on current aspects of the controversy. In brief, the previous work tells us the following:

•Takeovers benefit shareholders of target companies. Premiums in hostile offers historically exceed 30 percent on average, and in recent times have averaged about 50 percent.

•Acquiring-firm shareholders on average earn about 4 percent in hostile takeovers and roughly zero in mergers, although these returns seem to have declined from past levels.

•Takeovers do not waste credit or resources. Instead, they generate substantial gains: historically, 8 percent of the total value of both companies.

•Actions by managers that eliminate or prevent offers or mergers are most
suspect as harmful to shareholders.

•Golden parachutes for top-level managers do not, on average, harm shareholders.

•The activities of takeover specialists (such as Icahn, Posner, Steinberg, and Pickens) benefit shareholders on average.

•Merger and acquisition activity has not increased industrial concentration. Over 1200 divestitures valued at $59.9 billion occurred in 1986, also a record level (Grimm, 1986).

•Takeover gains do not come from the creation of monopoly power.

Although measurement problems make it difficult to estimate the returns to bidders as precisely as the returns to targets, it appears the bargaining power of target managers, coupled with competition among potential acquirers, grants a large share of the acquisition benefits to selling shareholders. In addition, federal and state regulation of tender offers appears to have strengthened the hand of target firms; premiums received by target-firm shareholders increased substantially after introduction of such regulation.

The Free Cash Flow Theory of Takeovers- A Financial Perspective on Mergers and Acquisitions and the Economy

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