Acquisition Values and Optimal Financial (In)Flexibility

According to conventional wisdom, the deep pockets of an incumbent serve to deter entry. In large part, the theoretical basis for this view rests upon the model of Bolton and Scharfstein (1990), who show that an unconstrained cashrich incumbent can fund predation in order to increase the likelihood of venture capitalists terminating projects. While there is certainly validity to the conventional view, our article builds upon the insights of Shleifer and Vishny (1992) to show that there is a dark side to an incumbent maintaining financial flexibility: a deep-pocketed incumbent represents an attractive merger partner and may inadvertently encourage entry for buyout. The argument starts from a simple premise: the willingness of financiers to fund projects is determined by the equilibrium value of entrant assets. Further, the highest value use of entrant assets often entails merging them with those of the incumbent (e.g., via trade sale). Consequently, expected merger payoffs should play an important part in determining the ability of entrants to obtain funding from venture capitalists. From this premise, our argument is straightforward. The sale of debt prior to merger increases a debt issuer’s share of merger surplus. Thus, the anticipation of a potential merger creates an incentive for targets and acquirers to issue debt. However, a mature incumbent enjoys a natural first-mover advantage in public debt markets. This first-mover advantage should be exercised, since preemptive debt issuance by an incumbent achieves three objectives: crowding out entrant debt, increasing the incumbent’s share of merger surplus, and reducing the likelihood of entry.

From “Acquisition Values and Optimal Financial (In)Flexibility” by Ulrich Hege and Christopher Hennessy

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