Tuesday, October 23, 2007

Research Papers Summaries Ch.22 Implementation and Management Guidelines for M&As

The summaries are of research papers referred to in the chapter 22. Implementation and Management Guidelines for M&As of Takeovers, Restructuring, and Corporate Governance by J. Fred Weston, Mark L. Mitchell, and J. Harold Mulherin, 4th Edition, Pearson Education, 2004.

These summaries help to deepen the knowledge in various topics covered in the book.


Summary of
Gregor Andrade, Mark Mitchell, and Erik Stafford,
“New Evidence and Perspectives on Mergers”
Journal of Economic Perspectives—Volume 15, Number 2— spring 2001—Pages 103–120

In this paper, authors provide evidence that merger activity in the 1990s, as in previous decades, strongly clusters by industry. Furthermore, they show that one particular kind of industry shock, deregulation, while important in previous periods, becomes a dominant factor in merger and acquisition activity after the late 1980s and accounts for nearly half of the merger activity since then. Authors tried to answer: What are the long-term effects of mergers, and what makes some successful and others not.

Mergers in the 1990s: What’s New?

In this paper, the stock database from the Center for Research in Security Prices (CRSP) at the University of Chicago, that contains pricing information for all firms listed in the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and Nasdaq was used. The focus was on mergers where both the acquirer and the target were publicly traded U.S.-based firms.

Aggregate Merger Activity

The authors write: The evidence is entirely consistent with the well-known view that there have been three major waves of takeover activity since the early 1960s. Interestingly, the 1960s wave contained many more deals, relative to the number of publicly available targets, than the 1980s.
It is astounding that the merger and acquisition activity in the 1990s seems to be even more dramatic and widespread, with number of deals comparable to the 1960s, and values similar to the 1980s.
• The first key distinction between mergers of 1980s and 1990s is the overwhelming use of stock as a method of payment during the latter decade. About 70 percent of all deals in the 1990s involved stock compensation, with 58 percent entirely stock financed. These numbers are approximately 50 percent more than in the 1980s.
• Only 4 percent of transactions in the 1990s involved a hostile bid at any point, compared to 14 percent in the 1980s, and a hostile bidder acquired less than 3 percent of targets
• The evidence for the 1980s by itself is interesting, because it suggests that the hostility of takeover activity during that time was less severe than generally believed.
• Finally, the 1990s continue a trend, begun in the 1970s, of an ever-increasing percentage of mergers where both parties are in the same industry

Although merger and acquisition activity, as discussed above, occurs in readily identifiable waves over time, these waves are not alike. It is also seen that industries that exhibit high levels of merger activity in one decade, are no more likely to do so in other decades. If mergers come in waves, but each wave is different in terms of industry composition, then a significant portion of merger activity might be due to industry level shocks like technology innovations, supply shocks or deregulation. Industries react to these shocks by restructuring, often via merger. Mitchell and Mulherin (1996) show that deregulation, oil price shocks, foreign competition, and financial innovations can explain a significant portion of takeover activity in the 1980s.

Of the shocks listed above, deregulation is an ideal candidate for analysis. First, it creates new investment opportunities for the industry. Second, it potentially removes long-standing barriers to merging and consolidating, which might have kept the industry artificially dispersed. Finally, it is fairly well-defined in time and in terms of parties affected, so empirically we know where and when to look. It is clear that deregulation was a key driver of merger activity over the last ten years.

The industry shock explanation for mergers has provided sufficient information about the timing of merger activity in an industry. Future empirical research on mergers should attempt to control for industry shocks.

Winners and Losers in the Merger Game

Measuring value creation (or destruction) resulting from mergers and determining how this incremental value is distributed among merger participants are two of the central objectives in finance and industrial organization merger research.

Mergers represent massive reallocations of resources within the economy, both within and across industries. From the firm’s perspective, mergers represent quite extraordinary events, often enabling a firm to double its size in a matter of months.
Stock Market Reaction to Merger Announcements
To study the value creation by mergers stock market corrections are studied by using traditional short-window event studies. Therefore, two commonly used event windows are the three days immediately surrounding the merger announcement—that is, from one day before to one day after the announcement—and a longer window beginning several days prior to the announcement and ending at the close of the merger.

• The combined average abnormal returns over this event window are fairly constant over decades and are reliably positive, suggesting that mergers do create shareholder value on average. If the event window is expanded to 20 days prior to announcement and ending on closing date statistical precision is considerably reduced.

• Target firm shareholders are clearly winners in merger transactions. The average three-day abnormal return for target firms is 16 percent, which rises to24 percent over the longer event window. Each decade is associated with merger activity concentrated in different industries, but the target firms consistently have abnormal returns of 16 percent in the announcement period. Together, these two observations suggest that merger premia are fairly similar across different types of merger transactions.

• The evidence on value creation for acquiring firm shareholders is not so clear cut. The average three-day abnormal return for acquirers is -0.7 percent, and over the longer event window, the average acquiring firm abnormal return is -3.8 percent. It is difficult to claim that acquiring firm shareholders are losers in merger transactions, but they clearly are not big winners.

Mergers seem to create value for shareholders overall, but the announcement period gains from mergers accrue entirely to the target firm shareholders. However it is said that mergers financed with stock, at least partially, have different value effects from mergers that are financed without any stock. From the acquiring firm’s perspective, stock-financed mergers can be viewed as two simultaneous transactions: a merger and an equity issue. On average, equity issues are associated with reliably negative abnormal returns of around -2 to -3 percent during the few days surrounding the announcement.

• Acquiring firms that use at least some stock to finance their acquisition have reliably negative three-day average abnormal returns of -1.5 percent, while acquirers that abstain from equity financing have average abnormal returns of 0.4 percent which are indistinguishable from zero.

• Target firm shareholders also do better when there is no equity financing. The three-day average abnormal return for target firms is 13 percent for stock-financed mergers and just over 20 percent for mergers financed without stock.

• The combined average abnormal returns for stock-financed mergers are zero whereas for mergers financed without any stock are reliably positive at 3.6 percent.

Long-Term Abnormal Returns
Several recent long-term event studies measuring negative abnormal returns over the three to five years following merger completion cast doubt on the interpretation of traditional short-window event study findings. In fact, some authors find that the long-term negative drift in acquiring firm stock prices overwhelms the positive combined stock price reaction at announcement, making the net wealth effect negative.

Large difference in long-term abnormal returns is based on:

• Stock financing and cash mergers: Loughran and Vijh (1997) found that acquiring firms using stock financing have abnormal returns of 224.2 percent over the five-year period after the merger, whereas the abnormal return is 18.5 percent for cash mergers.

• Book-equity ratio: Using the value/growth distinction, Rau and Vermaelen (1998) calculate three-year abnormal returns of 217.3 percent for glamour acquirers and 7.6 percent for value acquirers over the period 1980-1991.

There are a number of methodological concerns with long-term event studies. The basic concern stems from all tests of long-term abnormal performance being joint tests of stock market efficiency and a model of market equilibrium (Fama, 1970). If long-term expected returns can only be roughly estimated, then estimates of long-term abnormal returns are necessarily imprecise. An additional statistical concern with many long-term event studies is that the test statistics assume that abnormal returns are independent across firms. However, major corporate actions like mergers are not random events, and thus event samples are unlikely to consist of independent observations.

Pre- and Post-merger Profitability
Operating performance studies attempt to identify the sources of gains from mergers and to determine whether the expected gains at announcement are ever actually realized and reflected in the firm’s cash-flows. Ravenscraft and Scherer (1989) and Healy, Palepu and Ruback (1992) are two operating performance studies but they both reach different conclusions.

• Ravenscraft and Scherer (1989) examine target firm profitability over the period 1975 to 1977 using Line of Business data collected by the Federal Trade Commission and conclude that mergers destroy value on average.
• Healy, Palepu and Ruback (1992) examine post-merger operating performance for the 50 largest mergers between 1979 and 1984. They say that the post-merger operating performance improves relative to the industry benchmark.

Authors conclude:
Where Do We Stand?

Earlier studies on mergers conclude that mergers create values for the stakeholders of combined firms based on announcement-period stock price reaction; this study also concurs with prior reviews. We are inclined to defend the traditional view that mergers improve efficiency and that the gains to shareholders at merger announcement accurately reflect improved expectations of future cash flow performance. But the conclusion must be defended from several recent challenges.

• A first challenge is the research findings of a negative drift in acquiring firm stock prices following merger transactions, which would imply that the gains from mergers are overstated or nonexistent. These studies are skeptical as in order to measure long-term abnormal returns reliably, one must first be able to measure long-term expected returns precisely and no one has provided a convincing way to do this.

• A second challenge is that the underlying sources of the gains from mergers have not been identified. The positive effect of the merger is recognized by the stock market, but it is difficult for economic researchers to identify the sources of the gains with their much coarser information sets.

• A third challenge is that all of the gains from mergers seem to accrue to the target firm shareholders. The fact that mergers do not seem to benefit acquirers provides reason to worry about this analysis. So we can say that if mergers could be sorted by true underlying motivations, it may be that those which are undertaken for good reasons do benefit acquirers, but in the average statistics, these are cancelled out by mergers undertaken for less benign reasons. It is still puzzling from the data that acquirers rarely gain in spite of “synergy effect”. Another difficulty is to decide what the abnormal returns for acquiring firms should be? Empirical studies of other investment decisions, typically report very small (less than 1 percent) abnormal returns at the announcement of the investment decisions. In the light of such evidence, the announcement period an abnormal return of 0.4 percent for non-stock acquirers is same as those for other types of investments.

No comments: