Saturday, 21 November 2009

Hostile corporate takeovers - time to reform the rules

The attempted takeover of Cadbury by the American multinational conglomerate Kraft has not, unsurprisingly, been greeted with universal cheering throughout the country. Workers at Cadbury are now anxious about possible job losses, and politicians are worried about the relocation of those jobs to outside the UK and the political fall-out that might then ensue. After all, in 1993 Kraft took over another prominent English chocolatier, Terry's of York, and look what happened subsequently. In 2005 it closed the factory in York and moved the majority of its production to eastern Europe. The questions many are now asking are: will the same thing happen with Cadbury? And if so, what can be done to prevent it?

The neo-liberal proponents of unregulated free-market economics would doubtless argue that corporate mergers and acquisitions are all just a part of life under globalisation, that the benefits of such takeovers outweigh the disadvantages, and that the ownership of any one individual company does not really matter in the grand scheme of things. However, the current Director-General of the Confederation of British Industry (CBI), Richard Lambert, clearly thinks it does matter. So much so that he wants to see restrictions in the voting rights of shareholders who have owned their shares for less than six months. This restriction appears to be targeted at hedge funds which, it is claimed, have now acquired over 12% of Cadbury shares, presumably on the basis that they expect the share offer by Kraft to be increased. However, hedge funds are only doing what most market investors and speculators have done countless times before over the years. I know because I was one of them.

Back in 1992 I bought shares in Midland Bank when it was being lined up as a takeover target by HSBC. At the time the market speculation was that a counter bid would be made by Lloyds and so the share price could only go higher. It did. So you can hardly blame hedge funds or speculators for trying to cash in on what looked like a one way bet.

The problem here is not the speculation. Even if the rules on share ownership were changed to limit voting rights for short-term traders, speculators and hedge funds would still bet on the likely outcome of any takeover battle. The real problem is actually the whole issue of corporate takeovers, and in particular the destructive impact that the threat of a hostile takeover can have on the long term stability of a publicly quoted company. Unfortunately this is a problem that corporate leaders like Richard Lambert either tiptoe around, or completely fail to address; yet it is one of the most economically damaging issues facing this country, and is fundamental to addressing the numerous shortcomings of current corporate governance.

My principal objection to corporate takeovers is not that they play into the hands of speculators; it is that they are fundamentally anticompetitive and therefore, rather than being the natural bedfellows of neo-liberal economic thinking, actually distort the free markets that neo-liberals are forever proselytising. The reasoning behind this view is fairly easy to outline.

If a company takes over one of its competitors, it effectively increases its market share without having to work for it through comparative advantage. This process therefore represents an easy and lazy way for a company to appear to be increasing its profits without having to grow endogenously. Consequently, it does nothing to increase market competition and will actually act against the interests of the consumer by reducing choice and increasing prices. In fact from the perspective of the consumer, the merger process is no different in its outcome from that of a price-fixing cartel. Yet as both British Airways and the UK construction industry have recently found to their cost, such price-fixing cartels are illegal. Takeovers, on the other hand, are not. Nor do mergers and acquisitions do anything to significantly increase the GDP of the country. These, though, are not the only problems with mergers and acquisitions.

One of the most insidious consequences of the current takeover rules is the effect that the threat of takeover has on the long term stability of a particular company and its ability to plan investment in the medium or long term. In order to fend off potential predators, vulnerable companies are scared into maximising their share price on a day-by-day basis by paying ever higher dividends at the expense of future investment. So instead of investing in future research and development, money is haemorrhaged from the company to placate short-term investors. Nowhere is this more apparent than in the UK which, with its liberal takeover rules, also has one of the worst records for investment in industrial R&D of all the major economies.

Moreover, there is also a growing trend for companies that merged in the past to de-merge at a later date. As a case in point you need look no further than the company at the centre of this recent takeover controversy: Cadbury. Last year Cadbury was de-merged from Cadbury Schweppes after the two entities had enjoyed nearly forty years together, and acquired numerous other acquisitions over that period. Yet other mergers are less long-lasting. The acquisition of Imperial Tobacco by Hanson lasted barely ten years, for example.

The suspicion therefore remains that this seemingly never-ending cycle of corporate merging and de-merging may often be about as economically productive as a dog chasing its own tail. This poses some obvious questions in regard to the real shareholder benefits that can accrue from them in the longer term. If both companies in a merger and de-merger eventually end up back more or less where they were originally, who really benefits from the entire process, other than a few management consultants, merchant bankers and corporate lawyers who are generally at the heart of the whole process, and often responsible for driving much of it?

Then there is the other big driver of takeovers - debt. This is best exemplified by the tactic of the leveraged buyout (LBO) that is often associated with the takeovers made by private equity funds. In this respect the proposed takeover of Cadbury by Kraft is another prime example of how the creation of debt can be used to acquire a target company. Yet, with a debt-to-pretax profit ratio of 3.6, Kraft is already heavily leveraged. This highlights some of the inherent dangers that can arise from LBOs, and you only have to look back at some of the biggest LBOs of the 1980s to realise the scale of the problems that can arise. Given what has happened more recently, however, how can it be considered beneficial for the economy as a whole for both it and its largest companies to be saddled with unnecessary debt? After all, haven't we just seen the consequence of such practices? Nor does this growth in debt help the wider society as the interest on it is usually offset against any profits, thereby reducing the company's tax burden and thereby the government's income.

The final criticism that can be levelled at takeovers is that they are bad for free enterprise. In extremis, they result in the formation of oligopolies and quasi-monopolies. In crude terms, they are nothing more than a form of corporate cannibalism. The proponents of takeovers claim that hostile takeovers, or the threat of them, are a way of keeping management on their toes and ultimately removing poorly performing executives. But isn't that what shareholders are supposed to do? If it requires the executives of one company to purge those of another, then that merely proves that shareholders cannot ultimately hold the executives of either company to account. Executives are in effect beyond the reach of those they claim to be beholden to. That is not just an argument in favour of reforming takeover rules, but also one in favour of reforming the entire basis of corporate governance.

So, given the numerous negative impacts of takeovers on the wider economy, perhaps the question the likes of Richard Lambert should be asking is; how should we reform the rules that govern takeovers?

The first step should be to outlaw hostile takeovers, once and for all. That would then allow companies the relative luxury of being able to plan their future investment without forever looking over their shoulder to see which corporate predator was preparing to strike. It would also attract companies to the London Stock Exchange (LSE) as the LSE would then be perceived as a safe haven from corporate attack. If we are to champion greater competition and stability in our economy, however, I believe we need to go further.

As well as outlawing hostile takeovers, we should also be looking to reduce the burden of debt on public companies. That means vetoing all takeovers where a significant proportion of the finance for the takeover is provided by the creation of additional debt.

The low visibility of the Competition Commission (CC) in the area of corporate regulation in the UK is a testament to its current weakness, and an over-compensation within government towards light touch regulation. We should be setting more stringent limits on the definition of quasi-monopolies that not only outlaw hostile takeovers, but also prevent any agreed takeover between companies if the market share of either company, or the combined company, in any sector of its business, exceeds a predefined limit. For the sake of argument, I would set that limit at 10%. This is in contrast to the current regulations where the market share required for a significant lessening of competition (SLC) is not explicitly or objectively defined. This could mean that some judgements of the CC may appear to the outside observer to be too subjective in their basis, and therefore potentially prone to political pressure or bias.

In summary, the current policy towards corporate takeovers does little more than pander to corporate executive machismo, and contributes little to improving growth in GDP. Too many takeover battles are played out as gladiatorial combat at boardroom level, with the heads of the losing companies served up as trophies. It is also worth noting the scale of these mergers and acquisitions in the UK. When the FTSE 100 Share Index was introduced on the 3rd of January 1984 it was set at a level of 1000.0 while the total market capitalisation of all the 100 companies listed was barely in excess of £100bn. Twenty-five years later the FTSE 100 stood at 4434.17 while its market capitalisation stood at £1083bn. So while the FTSE 100 had risen by a factor of 4.4, its market capitalisation rose by a factor of 10. The different between those two numbers is, in a large part, down to mergers and acquisitions.