The Impact of the Structure of Debt on Target Gains

Consistent with prior literature, we find that increases in target leverage have a positive impact on returns to target shareholders irrespective of the source of debt. Even so, financing with bank debt has a remarkably different impact. If a target firm’s debt is primarily sourced from banks, as opposed to when debt is dominated by public or private non-bank debt, we find that an increase in target leverage from the 25th to the 75th percentile (1) raises the probability of a bid leading to a successful takeover by 14%, but (2) lowers returns to target shareholders by 5.2% in the event a takeover occurs. We also examine two explanations that arise naturally in M & A’s for this economically significant differential negative impact of bank debt on target shareholders. (3) Supporting the coinsurance effect as an explanation, we find that an increase in leverage from the 25th to the 75th percentile lowers returns to target shareholders by 8.7% if target debt is relatively risky and bank-dominated. (4) We also find support for the “hold-up” effect as another explanation. Now the increase in leverage decreases target shareholders’ returns by 7.5% if debt is bank-dominated and there is a single bank relationship. Finally, the transaction time to complete a takeover is also relatively smaller when debt is bank-dominated, since banks can more efficiently shift their debt to the typically more secure bidders.