Takeover vulnerability and the discipline of ESG overinvestment

Abstract

While takeovers serve a disciplinary role by replacing inefficient managers, the threat of takeovers may compel firms to divert attention from Environmental, Social and Governance (ESG) efforts as a strategic response to external pressure, especially when such firms are already overinvesting in ESG. We test this conjecture using a panel of 19,564 firm-year observations for NYSE and NASDAQ-listed firms from 1994 to 2019. Our findings indicate that ESG performance declines in the year preceding takeover attempts and, more generally, as firms' vulnerability to takeover bids increases. This effect is more pronounced in firms with prior ESG overinvestment, suggesting that firms respond to takeover threats by scaling back excess ESG initiatives. Further analysis reveals that this response is stronger in financially constrained firms, firms with more compliance-oriented and reputationally sensitive boards and firms where the CEO holds significant influence over the board. Conversely, the effect is weaker in firms led by highly capable managers and those with large shareholders, consistent with stronger governance constraining opportunistic ESG retrenchment under takeover pressure. Overall, our results suggest that firms' ESG decisions are shaped by takeover threats, with their response influenced by prior ESG investments, financial constraints and governance structure.