1 The Determinants of Merger Waves Klaus Gugler Dennis C.
Mueller B. Burcin Yurtoglu University of Vienna Department of
Economics Vienna, Austria
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2 Stylized facts on mergers Mergers come in waves Waves are
positively correlated with share prices and price/earnings
ratios
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4 An enormous number of hypotheses have been advanced to
explain why mergers take place. Most of the hypotheses have been
advanced to explain specific kinds of mergers. Many of them are
plausible explanations for some mergers, but they do not offer
convincing explanations for waves in aggregate merger
activity.
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5 Example: Vertical mergers to increase market power by
increasing barriers to entry (Comanor, 1967) to increase efficiency
by reducing transaction costs (Williamson, 1975). However, it is
difficult to imagine why the conditions necessary to make such
mergers profitable would appear across a sufficient number of
industries at a particular point in time to generate a wave in
aggregate merger activity, and why this point in time should
correspond to a stock market rally.
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6 For a merger wave to occur some sorts of mergers must greatly
increase in frequency at particular points in time. We want to
determine which hypotheses are likely to predict such variations in
the frequency of mergers over time. We examine four hypotheses that
have been put forward specifically as explanations of merger waves
1)the q-theory 2)the industry shocks hypothesis 3)the overvaluation
hypothesis 4)The managerial discretion hypothesis
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7 The first two are neoclassical in that they assume that (1)
managers maximize shareholders wealth (2) mergers are wealth
creating (3) capital market efficiency The other two may be
classified as behavioral, because they drop the assumption of
capital market efficiency and/or that managers maximize their
shareholders wealth.
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8 Neoclassical hypotheses The q-theory of mergers Jovanovic and
Rousseau (2002) The industry shocks hypothesis Mitchell and
Mulherin (1996) Harford (2004)
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9 Behavioral hypotheses The overvaluation hypothesis of mergers
Shleifer and Vishny (2003) Rhodes-Kropf and Viswanathan (2003)
Rhodes-Kropf, Robinson and Viswanathan (2003) The managerial
discretion hypothesis of mergers Marris (1964) Mueller (1969)
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10 The theories differ with respect to their predictions about
the determinants of mergers, (DM) the determinants of tender offers
versus friendly mergers, (TO vs. FM) the characteristics of target
firms the post-merger share performance of acquiring firms
(SP)
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11 The q-Theory of Mergers Underlying logic: Firms with qs >
1 can profitably expand by acquiring assets Critique: If managers
are maximizing shareholders wealth, and they have just become more
talented, then the mergers must benefit the acquirers shareholders.
Three options: new plant and equipment, used plant and equipment,
purchase another company. Why only latter two? (Jovanovic and
Rousseau, 2002); Premia rise in wave!
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13 Underlying logic: Shocks to industry (e.g., technological
innovations and deregulation) make mergers profitable and lead to
industry merger waves several industries must enter a wave at the
same time However, these shocks are not enough. There must be
sufficient capital liquidity to accommodate the asset reallocation.
(macroeconomic liquidity) Critique: Ignores association of wave and
stock market boom (Harford, 2004) Given its neoclassical nature,
the role of liquidity is problematic The Industry Shocks
Hypothesis
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14 Implications of the ISH Why does liquidity play an important
role? This can be reconciled with the efficient capital market
assumption, if one assumes that the firms making acquisitions are
undervalued, and thus cannot profitably finance an acquisition by
issuing shares. This interpretation of the ISH leads to a testable
prediction: firms undertaking acquisitions during a merger wave
will be undervalued.
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15 A second implication of the ISH There should be a relative
expansion of the amount of assets acquired by issuing debt during a
merger wave, because it is the fall in borrowing costs that
precipitates mergers in industries experiencing shocks. Table 2
presents the sources of finance for mergers over our sample period.
During the merger wave years (1995-2000), the relative importance
of debt actually fell.
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17 A third implication of the ISH is that acquirers
shareholders benefit from the mergers. An industry shock creates
profitable merger opportunities, and shareholder-wealth-maximizing
managers seize these opportunities. The assumption of capital
market efficiency implies that all wealth gains from mergers are
registered in share price movements at their announcements, and
thus that the shares of acquirers exhibit positive abnormal returns
at the announcements. Over longer time spans following the mergers
share performance should be indistinguishable from non- merging
firms. These predictions also differ from those of both the
managerial discretion and overvaluation hypotheses and thus
constitute tests to discriminate between the two sets of
hypotheses.
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18 Summary Both the q - and industry shocks theories suffer as
explanations of merger waves, because important implications of
them are not supported by the data. Target firms do not become
relatively inexpensive during a merger wave as predicted by the
q-theory, they become relatively more expensive than capital
equipment. Debt-financed mergers do not become relatively more
important, as predicted by the industry shocks hypothesis, they
become less important. An additional reason for rejecting these two
theories is that they fail to incorporate the most salient
characteristic of a merger wave into their explanation for it -the
markets over-optimism. Since this over-optimism plays a central
role in both behavioral theories of merger waves, we now discuss
the psychology of stock market booms.
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19 The Psychology of Stock Markets Todays share price should
have a definite relationship to a firms future earnings and
dividends. Shiller (1981): swings in stock prices in the USA over
the 20th century were far greater than could be accounted for by
subsequent swings in earnings and dividend payments. 1920s
optimistic 1930s pessimistic Assuming an average rate of growth of
g i from now to infinity, (1) becomes
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20 if k i > g i, which implies that the price/earnings ratio
of firm i should equal 1/(k i - g i ). In the 1990s stock market
boom, the S&P price/earnings ratio topped 40. Assuming an
average k i of 0.12, roughly the average return on stocks over the
period 1928-2004, then a P/E of 40 implies an expected, perpetual
growth rate of 0.095, which is more than four times the average
growth rate over the same period. Why should share prices rise to
unprecedented levels? a new era ? 1920s, mergers in the steel
industry, railroads community of interest: mergers will avoid much
economic waste and effect various economies coincident to
consolidation. 1960s conglomerate merger wave, conglomerate mergers
P/E magic 1990s, Harford (2005) industry shocks
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21 IndustryReason / Shock The insurance industry - 1998 big is
safer, leading to consolidation, especially in reinsurers. The
medical equipment industry - 1998 (1) acquisitions in core areas to
grow (2) acquisitions outside core areas to offer broad products to
increasingly consolidated customers (hospitals).
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22 The Managerial-Discretion Hypothesis Underlying logic:
Managers sacrifice profits for size and growth; constraints less
binding in waves due to increased optimism, high share prices, and
cash flows Critique: The MDH departs from most neoclassical
economics by assuming that managers pursue growth and not
shareholder wealth, and that stock market psychology influences
managers decisions
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23 managers utility can be expressed as a function of the
growth of their firms, g, and the threat of takeover, which is
inversely related to q
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25 Tests: Degree of speculation, Shiller (2000): (P/E t )
MDH-DM: MDH-TO: The MDH-DM receives less support for tender offers,
TO it, than for friendly mergers, FM it.
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26 MDH-SP1: The shares of acquiring firms earn large negative
abnormal returns over long time spans following the mergers, but
not immediately when they are announced. MDH-SP2: The post-merger
performance of acquirers shares is worse for mergers undertaken
during merger waves.
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27 The Overvalued Shares Hypothesis Underlying logic: Shleifer
and Vishny (2003); managers exchange their overvalued shares for
real assets of another company Critique: managers of overvalued
firm maximize welfare of current shareholders at the expense of new
ones; why pay high premia? (Any other asset would work)
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28 How to measure the overvaluation Logically difficult Others
(Verter, 2002; Ang and Cheng, 2003; Dong, Hirshleifer, Richardson
and Teoh, 2005; and RKRV, 2005) measures typically involve the
ratio of market to book value of equity or its reciprocal. all
firms in an industry have the same costs of capital and expected
growth rates and use equation 2 to estimate 1/( k i - g i ) for a
typical firm by regressing the market values of all firms in the
industry on their profits for a period of time when, based on the
aggregate P/E ratio for the S&P index, shares in aggregate do
not appear to be overpriced. Call this estimate of 1/( ki - gi),
.
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29 Tests: OVH-DM1: The assets acquired through mergers are
positively related to O it. OVH-DM2: The assets acquired through
mergers are positively related to dO it and O t, and both variables
have identical coefficients (dO it = O it - O t )
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30 OVH-TO: The OVH is better supported for friendly mergers
than for tender offers. OVH-TC: The probability that firm i is
acquired in t is a positive function of VS it and O it. OVH-SP1:
The shares of acquiring firms earn large negative abnormal returns
over long time spans following the mergers, but not immediately
when they are announced. OVH-SP2: The post-merger performance of
acquirers shares is worse for mergers undertaken during merger
waves.
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31 Previous Tests of the Two Hypotheses MDH Schwartz (1984)
Harford (1999) (1) cash rich companies are more likely to undertake
acquisitions, (2) their acquisitions are more likely to be
diversifying acquisitions, (3) the abnormal share price reaction of
bidders is negative and lower than for bidders which are not cash
rich, and (4) operating performance deteriorates after acquisitions
by cash rich companies.
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32 OVH Dong et al. (2002) focus mainly on the choice of payment
in mergers, and the pattern of post merger returns. Both Ang and
Cheng and RKRV find a positive relationship between the likelihood
that a firm becomes an acquirer and measures of overvaluation. Ang
and Cheng (2003, Table 3) include size in their logit regression to
predict the identities of acquirers. It picks up a positive
coefficient and is by far the most significant variable in the
equation.
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33 Returns to acquiring and target firm shareholders Three
categories: 1)very short windows, acquirers experience zero or
slightly positive returns 2)very short windows, acquirers
experience negative returns, and conclude that some
non-neoclassical hypothesis must explain mergers 3)event windows
spanning two, three or more years, none estimated positive returns
to acquirers over long windows
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36 Discriminating between the MDH and OVH Predicting the
Probability of Being Acquired (PAQ t ) NW: PAQ t = 3.99*10 -7 O it
- 0.00115 VS it, n=20,378, R 2 =0.0009 0.14 1.22 W: PAQ t =
-8.10*10 -6 O it - 0.00191 VS it, n=7,826, R 2 =0.0005 1.22
0.63
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37 Predicting the Means of Finance SF t = 63.82 + 5.19 O/MV t
141.33CF/MV t 2.87FF t +10.58TMV/MV t 28.51 4.49 10.72 9.46 4.17 N
= 3840, R 2 = 0.071 SF t, the fraction of assets acquired by a firm
in year t through the issuance of new shares O/MV t, the ratio of
the dollar amount by which an acquiring firm is overvalued to its
market value in year t, CF/MV t, the ratio of the acquiring firms
cash flow to its market value in year t, FF t, the federal funds
rate in year t, and TMV/MV t, the ratio of the targets market value
to the acquirers market value in year t
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38 Abnormal Returns We measure the ARs of acquiring companies
(A) using The benchmark is the mean return on a portfolio of
non-acquiring (NA) companies, which are in the same size decile as
the acquiring company. Datastream, using the changes in the total
return index, which is adjusted for dividend payments and share
splits.
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41 Conclusions Support for Behavioral Theories stronger than
for Neoclassical Some evidence against overvaluation hypothesis
Overvaluation hypothesis cannot explain increase in mergers
financed by debt or cash flows Managerial discretion hypothesis
first decide whether to make an acquisition or not, second how to
finance it.
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42 Based on our empirical results we offer the following
account of merger waves: At some points in time, shareholder
optimism begins to rise. This optimism in the market allows
managers to undertake wealth- destroying acquisitions, and not have
their announcements met by immediate declines in their companies
share prices. The number of wealth-destroying mergers increases
dramatically during a stock market boom creating a merger wave. As
the market learns about the mergers, it realizes that they will not
produce synergies, and that the theories behind them were false.
The markets optimism disappears and the share prices of acquiring
firms fall relative to those of other companies. Because of the
premia paid for the targets and the transaction costs of
integrating separate companies, the losses to shareholders of
companies making acquisitions are greater than one expects, simply
because the acquiring companies were overvalued.