Why Do Firms Adopting More Antitakeover Provisions Have Lower Valuation?

1. Why Do Firms Adopting More Antitakeover Provisions Have Lower Valuation?

2. Antitakeover Provisions (ATPs) • Firms adopt ATPs to defend themselves from possible hostile takeovers. • Antitakeover measures increase the bargaining position of target firms, • but they do not prevent many transactions. • Comment and Schwert (1995)

3. ATPs and Firm Value • Literature shows a negative relationship between firm value and the number of ATPs adopted • Gompers, et al. (2003) and Bebchuk, et al. (2009) • Debate on the negative relationship • adopting more ATPs destroys firm value ? • low-valued firms need more takeover defenses?

4. Why do some firms adopt more ATPs?Existing two hypotheses • Managerial entrenchment hypothesis • Emphasizing additional agency costs associated with adopting ATPs • since they may insulate managers from the discipline of the market for corporate control. • Gompers, et al. (2003) and Bebchuk, et al. (2009) • “Long-term value creation” hypothesis • When a firm has risky, long-term projects, • which might be in temporary difficulties, • ATPs allow its managers to create value without fear of losing control to rivals in a control contest. • Chemmanur and Jiao (2011)

5. A missing factor • Learning about mean profitability is not included in the debate. • Pastor and Veronesi (2003) • It is a relevant factor because • younger firms tend to adopt fewer ATPs; and • Younger firms also have higher valuation because • they have higher uncertainty about average profitability • due to a convex relation between the growth rate and future value • The resolution of uncertainty over time due to learning • is usually accompanied by a decline in firm valuation.

6. Learning and Firm Value Pastor and Veronesi (2003) • The M/B ratio is increasing in the uncertainty about book equity growth, σ2. • the convex relation between the growth rate and terminal value. • Uncertainty declines over a firm’s lifetime • due to learning effect • Younger firms have higher σ2 • and hence also higher M/B

7. Propose an alternative, rational explanation • To address: • why do some firms adopt more ATPs than others? • why does adopting more ATPs tend to be associated with lower valuation?

8. Our hypothesis • Knowing that there are potential agency costs associated with adopting ATPs, • firms—facing higher uncertainty—prefer to • give management less power until they prove their worth. • At which time, potential agency costs have declined and • firms add ATPs to protect their good and relatively low-valued assets from hostile takeovers

9. Furthermore (our hypothesis) • To mitigate agency costs of free cash flows generated from their good assets, higher G-index firms would • use more financial leverage, and • have higher propensity to pay dividends • Jensen (1986), Easterbrook (1984)

10. Our hypothesis vs. Entrenchment hypothesis • Take into account potential agency costs associated with adopting ATPs • from the entrenchment hypothesis • While entrenchment hypothesis emphasizes • additional agency costs associated with more ATP adoptions, • our hypothesis suggests that a firm would add more ATPs • when potential agency costs have declined and • when the firm recognizes that it have good assets, • which need to be protected because, at which time, • the firms could become easy takeover targets due to firm value declining with uncertainty

11. Our hypothesis vs. value creation hypothesis • Take into account a need for ATPs when firm value is low • from the value creation hypothesis • However, the value creation hypothesis seems to suggest that • a firm needs more ATPs if it faces higher uncertainty, • which is opposite to our hypothesis’s prediction that • facing lower uncertainty, a firm adopt more ATPs.

12. Uncertainty, ATP adoptions, and Firm Value Our hypothesis (cont’) • Our hypothesis suggests that • uncertainty is a common determinant of the G-index and of firm valuation • the negative relationship between firm value and the G-index is largely a manifestation of firm value declining with uncertainty about mean profitability.

13. A quick review of our findings • Low-G firms gradually increase G-index provisions over time as their uncertainty declines • Firm age is a very important determinant of a firm’s G-index • Low-G firms have more uncertainty and higher valuation, • the declines in both uncertainty and firm valuation over time are significantly faster for low-G firms. • High-G firms tend to use more debt and have higher propensity to pay dividends, and have a lower Tobin’s Q . • Neither the G-index nor the E-index has a significant effect on firm value after controlling for the learning effects

14. Data: 1990-2008 • Our sample consists of all firms IRRC database (except firms with dual-class shares) • IRRC released eight editions in 1990, 1993, 1995, 1998, 2000, 2002, 2004, and 2006, respectively. • stock returns from CRSP, annual financial data from Compustat. • G-Index; Gompers, Ishii, and Metrick (2003) • A firm's G-Index as the number of provisions that the firm has from the 24 IRRC provisions. • Entrenchment (E)- Index; Bebchuk, Cohen, and Ferrell (2009) • what matter in corporate governance are in six provisions out of the 24 IRRC provisions.

15. Definitions of variables • AGE: • minus the reciprocal of one plus firm age • VOLP • obtained from the residual variance of an AR(1) model fit on a firm’s ROE using a series of at least ten years of annual ROE • RESIDVOL • the residual variance from the market model • DIV • a dummy variable for diversified firms

16. Summary statistics:

17. Correlation:

18. Table 2. Characteristics of governance index portfolios

19. 3. Aging effects on firm value and uncertainty The learning theory suggests that uncertainty declines as firms age. We examine the effects of learning on firm valuation and on the resolution of uncertainty.

20. Figure 1. Tobin’s Q over time and learning effect by governance index

21. Table 3. AGE coefficients for governance index portfolios of Tobin’s Q regression

22. Table 4. AGE coefficients for governance index portfolios of ResidVol regression

23. 4. Why do firms change their ATPs? We hypothesize that knowing potential agency costs associated with adopting G-index provisions, firms facing higher uncertainty about mean profitability—which contributes to higher firm valuation (due to convexity)—prefer to give management less power until they prove their worth. Firms would gradually increase their G-index as more uncertainty is resolved over time. Firms would change their G-index if they know the quality of their assets is better

24. Figure 2. Trend in changes in governance index

25. Table 5. Event time evolution of characteristics prior to decisions to change G-index

26. Figure 3. Calendar time evolution of characteristics for firms that change G-index

27. 5. The determinants of the G-index Our focus on the extent to which the G-index is determined by the variables that proxy for uncertainty about average profitability, and by the instrumental variables for reducing potential agency costs.

28. Table 6. The determinants of the G-index

29. Table 8. Governance index in AGE portfolios

30. 6. The predicted G, the residual G, and firm value The entrenchment hypothesis argues that ATP adoptions lead to management entrenchment and destroy firm value and that the negative relationship reflects higher agency costs associated with more ATP adoptions. Our learning hypothesis suggests that firms facing lower uncertainty adopt more ATPs to protect their good assets from hostile takeovers and that the negative relationship reflects firm value declining with uncertainty about average profitability.

31. Table 9. Tobin’s Q and target governance index

32. Table 10. Tobin’s Q, governance index, and firm characteristics

33. 7. Conclusion • This study addresses • why some firms adopt more ATPs than others and • why more ATP adoptions are associated with lower firm value. • while low-G firms have higher valuation and higher uncertainty than high-G firms, • low-G firms experience steeper declines • in both uncertainty and firm value over time due to learning. • As uncertainty and firm value decline over time, • low-G firms would gradually add ATPs.

34. 7. Conclusion (cont’) • The negative relationship between firm value and the G-index • is a manifestation of firm value declines with uncertainty. • Our results suggest that • firms adopt ATPs to protect their good assets from hostile takeovers and • adding protections does not appear to lead managers to act suboptimally. • Therefore, the evidence is more consistent with • our learning hypothesis than the entrenchment hypothesis • for why firms adopt ATPs.