Taking Finance Seriously: How Debt Financing Distorts Bidding Outcomes in Corporate Takeovers

Economic analysis of corporate takeovers has traditionally advocated legal doctrines that ensure a target company in a takeover contest is acquired by the bidder willing to pay the most for it. The reason stems from the conventional assumption that a bidder’s offer price should reflect its ability to put a target’s assets to productive use. This Article challenges this assumption by turning to the success of private equity firms in outbidding publicly traded, strategic bidders during the takeover wave of 2004 to 2007. Using standard valuation modeling, this Article reveals how a critical component of any bidder’s valuation of a target stems from its source of acquisition financing. Specifically, a bidder’s ability to finance a takeover with debt can lead to a significant increase in its valuation of a target owing to a de facto government subsidy created by the deductibility of interest payments. Simultaneously, however, not every bidder has the ability to utilize debt financing to the same extent — a point emphasized in forty years of finance research. The result is that during periods of robust credit markets, such as occurred during 2004 to 2007, the highest bidders in takeover contests may often be those bidders, such as private equity firms, who are capable of using large amounts of debt financing. By highlighting the critical role of finance in explaining bidder valuations, this Article illustrates how accurate economic analysis of takeovers requires careful attention to bidders’ divergent financing decisions. Indeed, by failing to take finance seriously, traditional takeover scholarship may very well be advocating legal rules that promote inefficient takeovers.