History of Corporate Governance, Agency problem and moral hazard.

According to Hilt, E. (2014), there are three main issues that American corporate governance has

been concerned with over its long history. The managerial incentive problem that often arises

when ownership is highly diffused. Moral hazards arise when managers that seize more control,

as they might act in self-interested ways. The second problem occurs when the controlling

shareholders take actions that benefit themselves at the expense of the outside investors. The

third problem is regarding the power of the state to control the creation or expropriate existing

corporations.

The US did not have a well-developed corporation law statute at the time of the American Revolution.

Traditional practices offered answers to many questions regarding rights and obligations. Most of the

legal rights entitled to shareholders were specified in the corporation’s charter. Participation in voting

during annual meetings is the principal mechanism in governance of the corporation and the process of

elections are normally dictated by the charters. 

Regarding the second issue. The voting system was constructed to enhance the influence of smaller

investors during early years of corporations. The system is named graduated voting rights, in which the

votes per share is a decreasing function of the number of shares held by the investor. Contratuary to the

graduated rights system, the present dual class shares enhance the voting power of a founding

blockholder. The graduated voting rights system was imposed with the intention of addressing the

second problem. This rule attracted investments from smaller shareholders. However, this system can

be bypassed when shares are distributed to different family members, which may account for the

diminished use for graduated voting rights during the 19th century.
To address this issue, dividends and boards of directors were also implemented to the system of

corporate governance. Since the finances of corporations were not transparent, dividend payments

were used as a signal to investors that managers would not expropriate the asset of the company. The

names of the directors were publicized. The board stakes their own reputation for the business’ success.

Directors often included important figures from political parties, therefore, the interests of the

corporation would be represented in the state government. These two solutions helped to address

the second and third problem. Hilt, E. (2014)

How companies are incorporated. 

Until the mid to late nineteenth century, the only method for incorporation was  for the state to pass a

law. The law is the outcome of a negotiation between the incorporators with the content of the law

being the corporation’s charter. In addition to a contract among the incorporators, the formation of

corporations was a contract between the incorporators and the law. During this period of time, the

states frequently renegotiated the terms by granting charters Hilt, E. (2014). Resulted in the issues

regarding the states and its power to control corporations.

In the present, the procedure for incorporating a business in American is routine and inexpensive. The

required procedure requires the applicant to submit a certification of incorporation to the secretary of

states and pays a nominal fee. A separate document composed by the incorporators details the

structure of the internal relations of the firm. The incorporators have great freedom to structure their

corporation, as well as the choice to incorporate in any state irrespective of the operating location; 85%

of businesses incorporating out of state choose Delaware . Hilt, E. (2014)

Rise of hostile bid takeover, compared to removing board members through the corporate statues.

According to Auerbach (1988), “Corporate restructuring through hostile takeover, merger, or

management buyout are wealth enhancing in the sense that the combined market value of the acquiring

and the acquired companies usually rises”. The premium received by shareholders derives from the

improvement from restructuring. Economists also suggested the improved profitability of merged

companies results in an increase in market value, as evidence suggests that market power does not

influence the profitability in the case of takeover (Auerbach, 1988).  

The reason of hostile takeover

Auerbach (1988) identified two broad classes of takeovers as disciplinary takeovers and synergistic

takeovers. The former aims to correct the non-value-maximizing practices from management. The latter

seek to combine the firms, from gaining market power, to merging research facilities. Synergistic

takeovers realize the gain from the integration of the businesses. In the case of synergistic takeovers,

there might exist gains for both the managers and shareholders (Auerbach, 1988).

In the case of a hostile takeover, managers of the firm are often unsatisfied with changes in operation or

compensation received in exchange for the control of the firm. A study in the 1980 used the Fortune 500

as a sample. Findings stated that 82 companies were acquired by third parties or have experienced a

management buyout. Out of the 82 takeovers, 40 started hostile and 42 friendly. Friendly targets seem

to have a higher board ownership than hostile targets, more likely to be run by the founder or the

founder’s family, and the likelihood of the target being friendly is also correlated to higher management
ownership. Higher management ownership contributes to a lower incentive of resistance as the financial

success of the manager can be improved by a successful acquisition (Auerbach, 1988).

Disciplinary takeovers are more likely to be hostile compared to the average. While synergistic takeovers

are more likely to be friendly. The financial characteristics of the friendly targets are often similar to the

average firm. In contrast, hostile targets are often older firms with poor performance contributed with a

mismanagement of resources, most noticeably tangible assets (Auerbach, 1988). The act of hostile

takeover can be interpreted as a method to redeploy tangible assets to be used more efficiently. The

redeployments are likely to be unacceptable to management. White knight or management buyout

serves as the alternative to replicate the effects of redeployment.

Economics of LBO or proxy contests.

A recent research published by De Maeseneire, W. & Brinkhuis, S. (2012) aimed to determined the drive
of leverage in leveraged buyout. The research is performed using cross-section regression analysis on a
unique and self-constructed dataset on LBO. The dataset contains information of 126 European PE
sponsored buyouts that was completed between June 2000 and 2007. On average 71 percent of buyout
consist od debt and the percentage has been rising over time.

EBITDA multiples are primarily used by practitioners as it relates debt financing to the firm’s ability to
repay debt. Exceptionally high debt and enterprise value multiples are considered aggressive financing,
while low multiples are considered a sign of undervaluation. There are other variables that contribute to
the value of the multiples. In general, buyout in the US, stables industries, and larger buyouts tend to be
financed with a higher multiple. In a regression analysis, it was found that firm size, profitability, growth
potential, and collateral asset are all have significant impact on leverage.

The findings of this research suggests that the classical capital structure theories are unable to explain
leverage in LBOs. The capital structure with respect to LBO is heavily influenced by conditions in the
debt market. LBOs utilizes relatively more debt when the credit conditions are loose. The reputation of
the PE player is also a contributing factor on the financing choice regarding LBOs. With the participation
of a more reputable PE fund generally results in a higher leverage level.
De Maeseneire, W. & Brinkhuis, S. (2012), What drives leverage in leveraged buyouts? An
analysis of European leveraged buyouts’ capital structure. Accounting & Finance, 52: 155-182.
https://doi.org/10.1111/j.1467-629X.2011.00431.x3

AXELSON, U., JENKINSON, T., STRÖMBERG, P., & WEISBACH, M. (2013). Borrow Cheap, Buy
High? The Determinants of Leverage and Pricing in Buyouts. The Journal of Finance, 68(6), 2223-
2267. Retrieved January 22, 2021, from http://www.jstor.org/stable/42002567

Engel, N., Braun, R., & Achleitner, A.-K. (2012). Leverage and the performance of buyouts :
(How) does the use of debt Impact equity returns? Zeitschrift Für Betriebswirtschaft, 82(5), 451–
490. https://doi.org/10.1007/s11573-012-0559-y
This one provide evidence of return
Why firms take on additional debt and place the liabilities on the acquired companies balance sheet.

The fact that shareholders can elect directors is insufficient to remedy the lost opportunity to tender
to a bid.

Investment Horizons, management entrenchment and divergence of interests.

Auerbach, A. J. (1988). Corporate takeovers: causes and consequences. University of Chicago Press.
https://books-scholarsportal-info.myaccess.library.utoronto.ca/en/read?
id=/ebooks/ebooks2/ucpbooks/2012-03-30/1/9780226032160#page=8

This source argues the pros and cons of takeover given a few scenarios. Might be useful

Hilt, E. (2014). History of American Corporate Governance: Law, Institutions, and Politics. Annual Review
of Financial Economics, 6(1), 1–21. https://doi.org/10.1146/annurev-financial-110613-034509

Bayer, C., & Burhop, C. (2009). Corporate governance and incentive contracts: Historical evidence from a
legal reform. Explorations in Economic History, 46(4), 464–481.
https://doi.org/10.1016/j.eeh.2009.05.002

Bebchuk, L., Cohen, A., & Ferrell, A. (2009). What Matters in Corporate Governance? The Review of Financial
Studies, 22(2), 783-827. http://www.jstor.org/stable/30226006

Auerbach, A. J. (1988). Corporate takeovers: causes and consequences. University of Chicago Press.

https://books-scholarsportal-info.myaccess.library.utoronto.ca/en/read?
id=/ebooks/ebooks2/ucpbooks/2012-03-30/1/9780226032160#page=8