Dr. Klein is Assistant Professor of Economics at the University of Georgia, and an Adjunct Scholar of the Ludwig von Mises Institute.
In 1989 the New York investment banking firm of Kohlberg Kravis Roberts & Co. (KKR) shocked the corporate world by acquiring RJR-Nabisco, the food and cigarette giant ranking nineteenth on the Fortune 500 with $17 billion of annual sales. The final purchase price—an unheard-of $24.7 billion—was (and remains) the largest sum ever paid by one firm to buy out another. What’s more, KKR financed the acquisition through debt, by issuing high-risk, high-yield bonds. Highly visible “leveraged buy-outs” (LBOs) such as this one became the defining feature of the takeover wave of the 1980s. Suddenly, everyone was talking about LBOs, divestitures, repurchases, free cash flows, and other formerly exotic activities. Takeover specialists like Michael Milken and Ivan Boesky became regulars on the nightly news. Accompanying the unprecedented volume of takeover activity during this period was a new “official” 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 shareholder. The critics invented a new, colorful language to describe the proceedings: takeover specialists were “raiders”; high-yield bonds became “junk bonds”; tender offers resisted by incumbent management 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 financier Gordon Gecko (played by Michael Douglas) 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 symptomatic of the excesses on Wall Street,” according to one more sober account. It was “the culmination of a process that had gone badly out of control.”
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 productive assets are privately owned and traded, these assets will tend to move toward their highest valued uses. Changes in the ownership of corporations, then, are just 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: acquisition occurs when the value of an existing firm’s assets is greater to an outside party than to its current owners. This difference in valuation may be because the buying firm believes its management or a new management 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 will quickly arrive and replace them.
The Disciplinary Role of Takeovers
Since Adolph Berle and Gardiner Means published their 1932 book The Modern Corporation 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 vacations, 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 implies 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.” Manne argued that managerial discretion will be limited as long as there exists an active market for control of corporations. 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 incumbent management. Hence while managers may indeed hold considerable autonomy over the day-to-day operations of the firm, the stock market places strict limits on their behavior.
Interestingly, the Austrian economist Ludwig von Mises had expressed the same basic insight sixteen years earlier, in his great work Human Action. In a passage distinguishing what Mises calls “profit management” from “bureaucratic management,” he pointed out that despite the importance of the salaried manager in modern business life, the shareholders make the ultimate decisions about allocating resources to the firm in their decisions to buy and sell stock:
[The Berle-Means] doctrine disregards entirely 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 business. . . . The changes in the prices of common 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.
Mises does not identify the takeover mechanism per se as a means for capitalists to exercise control—takeovers were less popular before the late 1950s, when the tender offer began 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 market for managers. Instead, it is the capital market, where entrepreneurial judgments are exercised and decisions carried out.
Are Mergers Efficient?
Mergers and acquisitions, like other business practices that do not conform to textbook models of “perfect competition,” have long been viewed with suspicion by antitrust and regulatory authorities. The problem is that the notion of perfect competition is a hugely inappropriate guide to public policy. In the real world of uncertainty, error, and constant change, “efficiency” means nothing other than directing 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 restrictions 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. Scherer’s (1987) large-scale study of manufacturing 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 during the 1960s and 1970s were eventually divested. Ravenscraft and Scherer conclude that mergers typically promote managerial “empire building” rather than efficiency, and they support increased restrictions on takeover activity. Michael Jensen, founder of the Journal of Financial Economics, suggests changes in the tax code to favor dividends and share repurchases over direct reinvestment, thus limiting managers’ ability to channel “free cash flow” into unproductive acquisitions.
Public Policy and the Stock Market
But the fact that some mergers—indeed, many mergers, takeovers, and reorganizations—turn out to be unprofitable does not imply “market failure” or prescribe any policy response. Errors will always be made in a world of uncertainty. Even the financial markets, which aggregate the collective wisdom 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 reward, 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.
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 government 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 commissions are required. In short, that business often fails is surprising only to those committed to textbook models of competition in which the very notion of “failure” is defined away. Such models are surely no guide to public policy. 
3. There are other mechanisms to limit managers’ discretionary activities, such as the market for managers itself. On this see Eugene F. Fama, “Agency Problems and the Theory of the Firm,” Journal of Political 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 Putterman, ed., The Economic Nature of the Firm: A Reader (Cambridge: Cambridge University Press, 1986).
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 shareholders will refuse to sell their 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.