Free cash flow and takeover threats: an experimental study.

• Author: Oprea, Ryan

1. Introduction

   This paper reports an experiment examining the effects of takeover threats and cash flow on managerial decision making. The laboratory environment is motivated by Michael Jensen's (1986) free cash flow theory of takeovers, which holds that firms that generate cash flow with no high-return projects to spend it on will suffer from agency problems. Rather than disgorge cash to investors, managers with high cash inflows will spend the money on zero return vanity projects, empire building, frivolous spending, or even outright self-payment--behavior I will collectively refer to as self-dealing. These agency problems, Jensen argues, are reduced when institutional factors in capital markets allow investors to force reorganization by selling their interests in the firm. As Jensen (1986) and Scharfstein (1988) have noted, because these takeovers are frequently motivated by a desire to overthrow management, the very threat of takeover can motivate managers to keep investors happy by paying out free cash as dividends, instead of engaging in self-dealing. In this sense takeover threats are potentially good for investors.

   Other authors, such as Stein (1988), have emphasized takeover threats' potential to cause myopia in management. When returns are uncertain, managers may be motivated to make decisions that please investors in the short run, ignoring long-run returns in the process. Managers may convince investors to reject takeover bids in the short run by focusing on generating short-run returns even if at the expense of long-term returns. In other words, takeover threats might make managers myopic, which may ultimately be bad for investors.

   Our experiment was designed to study these two potential effects of takeover threats. The experimental design models the firm as a stochastically evolving flow of cash, owned by a representative investor and governed by a manager. In each period the manager chooses how much of the firm's cash to leave in the firm, how much to pay out to the investor in dividends, and how much to deal to herself. The firm is at its efficient scale, lacking growth prospects but still generating cash flow. The lack of growth prospects means that neither manager nor investor can influence cash flow. The existence of cash flow gives managers scope for dividend payouts and room for self-dealing. In the design, if the firms cash flow ever drops below zero, the firm is automatically liquidated by creditors, the manager is deposed, and the investor loses remaining interest (i.e., the experiment ends). One of the treatment variables varied in this study is whether the firm faces a takeover threat. In No Takeover treatments, the investor has no effect on the payouts of the manager and is therefore completely dependent on the manager's goodwill for earnings. In Takeover treatments, the investor can choose at any point to sell the firm to the experimenter at a fixed price, thereby deposing of the manager and ending the experiment. The second treatment variable is cash flow. In High Cash experiments, the average amount of cash generated by the firm is higher than in Low Cash experiments.

   This model of the firm closely mirrors the one described in free cash flow theory. The firm generates positive cash flow, but there are no productive uses for it within the firm. Without viable investment projects, this positive cash flow can either be spent to benefit the manager (for instance, on unprofitable empire building, vanity projects, or even outright theft), or it can be paid out as dividends. This tradeoff between two uses of free cash creates a conflict of interest between manager and investor and a potential for agency problems.

   The typical concern (associated, for example, with Stein 1988) regarding takeover-inspired myopia is that takeover threats might cause managers to make inefficient project choices. Managers may choose to invest in short-run, quick return, or low-risk projects instead of long-term growth projects to return dividends to managers and stave off corporate raiders. It is difficult to study this sort of myopia in the type of environment described by free cash flow theory because in such environments, and so in the experimental design, the firm has no growth projects available. However, a different opportunity for myopia presents itself in the design. In addition to having direct value to investors and managers, cash insures the firm against runs of bad luck in earnings that can lead to liquidation. Optimality requires managers to make no cash withdraws until cash exceeds a critical safe barrier level. This robs the manager of an opportunity to signal willingness to return funds early in the life of the firm. Under an optimal withdraw policy, investors must bear substantial risk with little assurance that their managers are willing to make cooperative distributions of cash. To assuage this risk and deter investors from accepting takeover bids, managers may have incentives to make withdraws below the optimal barrier to signal that they are of a cooperative type. There is therefore some behavioral scope for myopic distribution policies as a consequence of the takeover threat.

   The evidence broadly supports the relevant conjectures made by free cash flow theory. Free cash significantly worsens managerial misbehavior. Moreover, takeover threats are effective at reducing these agency problems but only in high cash flow firms. Finally takeover threats inspire myopic withdraws, although only in low cash flow firms. As ! argue below, this is consistent with the sort of myopic generosity signaling described above.

   Early observations on the governance value of the takeover threat were provided by Manne (1965); although, the pioneering formal work on the mechanics of how takeovers can force managerial payout of dividends was conducted by Grossman and Hart (1980). The theoretical work that most directly addresses the use of takeover threats in solving agency problems between managers and stockholders is Scharfstein (1988). A useful survey on the agency problems that exist between sources of finance and management is provided by Shleifer and Vishney (1997). There is also a small experimental literature on takeovers. Kale and Noe (1997) report an experiment in which a number of investors, each holding a single share of a company, must simultaneously decide whether to accept an exogenous takeover bid that will be accepted only if a threshold number of subjects choose to accept the bid. The conclusions of Cadsby and Maynes (1998) are similar to those of Kale and Noe (1997) except that investors have multiple shares and the bid requires only that a threshold number of shares (rather than a threshold number of players) be sold. Gillette and Noe (2006) study the effects of resolicitation options on free riding in takeover bids. Hamaguchi et al. (2003) also study the free rider problems that plague takeover attempts, formally studying popular models of the problem. The types of free rider problems explored in these papers are abstracted from in the design reported here. Croson et al. (2006) study bargaining over synergies from takeovers and mergers in an environment quite different from the one studied here.

   In section 2, the first part presents the basic model of the firm used in this experiment, and the next part describes the treatments and parameters used. The next two parts of this section describe optimal withdraw behavior and a testable hypothesis regarding myopic withdraws in the experiment, respectively. The last two parts of this section describe the main experimental questions and the experimental procedures. Section 3 reports the results of the experiment, and the paper concludes in section 4.

2. Experimental Design

   Model of the Firm

   Consider a firm consisting of one manager paired with one investor. The main attribute of the firm in period t is its free cash, [c.sub.t], which evolves over time according to three factors:

1. An independently and identically distributed shock [epsilon] ~ N([mu], [[sigma].sub.2]) is added to the firm's free cash every period.

2. In each period, the manager chooses a non-negative amount w, to withdraw from the firm's free cash. I will call this the manager's withdraw policy.

3. In each period, the manager chooses how to distribute the withdraw between herself and the investor. In particular, the manager chooses a fraction [s.sub.t] of the withdraw to pay out to herself and a fraction [d.sub.t] to pay out to the investor, where [d.sub.t] + [s.sub.t] = 1. I will call [s.sub.t] the manager's self-dealing policy and [d.sub.t] the manager's dividend policy.

   Thus the firm's free cash in period t is

   [c.sub.t] = [c.sub.t-1] - [w.sub.t-1] + [[epsilon].sub.t]. (1)

   The manager has two sources of income. She is paid a wage, e, for each period the firm is in business, and she is paid her self-dealing withdraws. The manager's cumulative earnings in period t is therefore

   [[pi].sup.M.sub.t] = [[pi].sup.M.sub.t - 1] + [s.sub.t] + e. (2)

   The investor is paid...