German pharma giant Bayer’s acquisition of Monsanto is only one prominent case of leveraged buyouts (LBOs), which have been flourishing since the 1990s (see Figure). After Bayer has paid 66 billion dollars for Monsanto, the stock value of the merged enterprise has collapsed below Bayer’s pre-merger value. Bayer faces more than 10,000 US lawsuits over cancer allegations for Monsanto’s glyphosate-based herbicides, which were foreseeable prior to the leveraged takeover. What is driving this LBO activity if not profitability?
Global LBO Deal Value
Source: Bain Global Equity Report.
One explanation is the conflict of interest between owners of a company and its managers. Whereas owners wish to maximize the firm value, managers want to maximize their personal income. Managerial remuneration tends to rise with firm size (Murphy 1985). If managers want to reward performance of employees through promotion rather than bonuses, firm size is relevant to having a sufficient supply of high-ranked positions (Baker, Gibbs, Holmstrom 1993). Acquisitions via LBOs are an effective way to increase the firm size, even if the deal turns out to be a loss for shareholders.
In case of firms with sufficient free cash flow, i.e. internal funds, the shareholders may find it difficult to oppose the takeover due to asymmetric information. They cannot properly assess the profitability of a planned takeover and therefore approve of it. As argued by Mehran and Peristiani (2013) external capital can be a mechanism to enforce discipline in LBOs. The reason is that creditors can take the firm to the bankruptcy court if it fails to pay interest that is due (Jensen 1986). This argument is in line with the argument that capital markets ensure an efficient allocation of resources by disciplining the market participants to put capital to its most productive use (Mises 1912).
Nevertheless, as Bayer-Monsanto shows, that takeovers can turn sour, even if they are credit-financed. One reason could be that since the late 1980s central banks have undermined the disciplinary role of debt by pushing interest rates to ever lower levels. With interest rates near zero and not being expected to rise, managers without internal funds can rely on cheap large-scale external funds to increase the firm size even if no significant efficiency gains are achieved. Hoffmann and Schnabl (2016) have argued that the persistently benign liquidity conditions created by central banks have released the pressure on enterprises for efficiency gains and innovation. Once, Kornai (1986) dubbed similar pattern for the central and eastern European planning economies as “soft budget constraints”.
From this point of view large enterprises may have embarked on risky LBOs, because they regard themselves as “too big to fail”, with their potential losses to be covered by the public. In the case of Bayer, as the risks are becoming visible at the brink of the recession, ECB and Fed can be expected to loosen monetary policy again. This would reanimate the stock market value of Bayer but comes at the cost of savers facing lower real deposit rates and government bond yields. In addition, the Bayer management has announced to cut 12,000 jobs. To prevent this, trade unions are likely to accept wage cuts, which would allow it to shift the costs of the deal to the employees. Also, subcontractors and their employees can be expected to shoulder parts of the costs.
As this is likely to cause social discontent, to resolve the problem of unhealthy LBO overinvestments, a reversal of ultra-loose monetary policy is necessary to reinstall the disciplinary function of interest rates. Only if servicing debt is a strong commitment, i.e. ‘a hard budget constraint’, external financing can help shareholders to prevent their managers from embarking on costly adventures.
References:
Baker, George / Gibbs, Michael / Holmstrom, Bengt (1993): Hierarchies and Compensation – A case Study, European Economic Review 37, pp. 366-378.
Kornai, Janos (1986): The Soft Budget Constraint, Kyklos 39(1), pp. 3-30.
Jensen, Michael (1986): Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, American Economic Review 76(2), pp. 323-329.
Hoffmann, Andreas / Schnabl, Gunther (2016): Adverse Effects of Unconventional Monetary Policy, Cato Journal 36(3), pp. 449-484.
Mehran, Hamid / Peristiani, Stavros (2013): US Leveraged Buyouts: The Importance of Financial Visibility, Liberty Street Economics Blog by the Federal Reserve Bank of New York, 28.8.13.
Mises, Ludwig von (1912): Die Theorie des Geldes und der Umgangsmittel, Duncker and Humblot, Leipzig.
Murphy, Kevin (1985): Corporate Performance and Managerial Remuneration: An Empirical Analysis, Journal of Accounting and Economics 7 (1-3), pp. 11-42.
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