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We propose that an active takeover market provides incentives by offering acquisition opportunities to successful managers. This allows firms to reduce performance-based compensation and can rationalize loss-making acquisitions. At the same time, takeovers remain a substitute for board dismissal in the replacement of poorly performing managers. When choosing its acquisition policy and the quality of its board, each firm ignores the adverse effect on other firms’ acquisition opportunities and takeover threat. As a result, the takeover market is not sufficiently liquid and too few takeovers occur. Furthermore, the liquidity in the takeover and managerial labour markets are inversely related. When poaching successful managers becomes more profitable, firms invest more in their internal governance which in turn reduces the incidence of takeovers.

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