Democracy as a fundamental determinant of cross-border merger activity

By | October 6, 2022

Does democracy shape international merger activity? The short answer is yes, because democratic institutions are conducive to higher-quality corporate governance. In a new paper, we examine 104,425 cross-border transactions in 58 countries from the mid-1980s and find merger flows involve acquirers from more democratic countries than their targets. This result is primarily driven by a “pull” factor, whereby firms from countries with weak democratic institutions attract cross-border deals to benefit from improved corporate governance. 


We rely on an extensive transaction-level data set covering 58 countries between 1985 and 2018 and apply a gravity model to explain the intensity of cross-border mergers between two countries as a function of various country characteristics, measured as differences between acquirer and target countries (such as cultural and geographic distance between country pairs). This approach allows us to identify the effect of differences in democracy between country pairs on the intensity of their cross-border flows. Specifically, we focus on differences in democratic institutions, that is, the formal rules typically laid down by explicit constitutional provisions guaranteeing that citizens can express their preferences about policies and leaders and ensuring constraints on the exercise of executive power. In the tradition of classical political economy, we argue democratic institutions are fundamental because they determine contracting institutions, such as investor protection. 

Empirical Regularities 

We report two novel empirical regularities in the analysis of the determinants of cross-border mergers.  

First, we provide evidence suggesting the closer two countries are relative to each other in terms of levels of democracy, the more intense the merger flows between them. This result is perhaps not surprising but is consistent with the general idea that cross-border transactions are facilitated when contracting costs associated with combining two firms across borders are low. When countries are endowed with similar democratic institutions, contracting parties may face lower legal, administrative, and bureaucratic constraints. Therefore, it is expected that the lower these constraints are, the easier it is to complete a transaction or realize synergy gains. 

Second, we find that the democracy effect is also directional: substantial merger flows involve acquirers from countries with better democratic institutions than their targets. The democracy effect is sizeable: a one-standard-deviation increase in the differences in democracy between two countries is associated with more than two percentage points higher cross-border merger volume, which corresponds to 50% of its sample mean. Comparing with other important determinants of cross-border mergers shown in prior work, the democracy effect we document is almost two times larger than the effect of culture and more than three times larger than geography. This result survives a battery of robustness tests. For example, and importantly, it continues to hold if we exclude established democracies characterized by a dynamic market for corporate control, such as the United States, the United Kingdom, or Canada. 

Explaining the Democracy Effect 

We then shed light on the mechanism behind the democracy effect. The cross-border M&A literature has shown that differences in corporate governance can motivate a merger if the target firm’s shareholders can benefit from “bonding” to higher governance standards after being acquired by a firm from a country with better accounting standards and stronger shareholder protection. To the extent that stronger democratic institutions promote better corporate governance, the bonding view implies that firms from less democratic countries are more likely to engage in cross-border deals with acquirers from more democratic countries.  

International law prescribes that the nationality of a firm changes when the foreign acquiring firm engages in a complete-control (100%) transaction. A direct implication is that the law applied to the target firm (and thereby the protection provided by such law to the target firm’s shareholders) also changes. Interestingly, we uncover that the increased cross-border merger flows from acquirers with stronger democratic institutions are fully due to the complete-control transactions in our sample.  

To further understand the motives behind these transactions, we examine whether push and/or pull factors are at work. We find that pull factors primarily drive our results on cross-border merger flows; that is, merger flows are more influenced by the weak democratic institutions in the target’s home country than the superior democratic institutions in the acquirer’s home country. These results are consistent with the bonding view whereby the target firm usually adopts the governance standards of the country of the acquiring firm. Furthermore, according to this view, the pull factor should be weaker for countries with stronger corporate governance as the target firm’s shareholders would benefit less from bonding after being acquired. We also observe that the pull factor is less pronounced when the target’s home country has higher accounting standards and stronger shareholder protection.  

Last, we look at share price reactions to cross-border deal announcements. Cross-border mergers allow target firms to alter the level of protection they provide to their shareholders because they usually import the acquiring firm’s corporate governance standards by law. Therefore, the market should assign more value to better protection. We find that target firms’ abnormal returns are positive and significantly larger when acquirers are from more democratic countries. However, we do not find a symmetric effect on acquiring firms’ abnormal returns. The asymmetry implies that complete-control transactions involving acquirers from stronger democracies than targets are not value-destroying and primarily benefit target firms’ shareholders.  

Overall, the collage of evidence appears consistent with a bonding view in the cross-border M&A literature. We also note that the absence of push factors and effects on acquiring firms’ returns are inconsistent with a pure “economic development” view. According to this view, firms in established democracies, enjoying enhanced economic dynamism, should also be incentivized to find deal opportunities abroad and benefit from them. 


Our work mainly contributes to two different kinds of literature.  

First, it adds to the law and finance literature, showing that laws and regulations protecting outside investors explain cross-country variations in merger activity. The argument—usually associated with the work of La Porta, Lopez-de-Silanes, Schleifer, and Vishny—is that legal protection of outside investors facilitates control transfers by reducing agency costs and information asymmetries and improving corporate governance. However, investor protection remains a proximate cause of cross-border merger activity rather than its fundamental source. Here, in the tradition of classical political economy, we argue that democratic institutions are fundamental because they are more difficult to change than other institutions. Most notably, they change more slowly than investor protection. Our paper builds on and complements the law and finance literature by presenting evidence that democratic institutions have a fundamental influence on cross-border merger flows. It further shows that firms in less-advanced democracies attract cross-border deals to benefit from better governance standards in more established democracies (conducive to higher-quality corporate governance). In that sense, our findings resonate with the idea that cross-border merger activity is an important channel for global convergence in corporate governance standards. 

Second, our work advances the political economy and development literature by pointing out that cross-border mergers, as foreign investments, are potentially an important mechanism through which democracy affects long-run economic growth. The role of cross-border merger flows has received, thus far, no attention in this literature. Indeed, democracy does cause growth, in part due to pro-growth reforms. Our paper stresses that reforms aimed to improve investor protection accounts for the impact of democracy on cross-border merger flows. 


Muhammad Farooq Ahmad is an Associate Professor of Finance at SKEMA Business School, France 

Thomas Lambert is an Associate Professor of Finance at Rotterdam School of Management, Netherlands 

Jose M. Martin-Flores is an Assistant Professor of Finance at CUNEF Universidad, Spain 

Arthur Petit-Romec is an Assistant Professor of Finance at Toulouse Business School, France  

This post is based on their paper, “Does Democracy Shape International Merger Activity?” available on SSRN. 

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