DSpace at VNU: Motives for Mergers and Acquisitions: Ex-PostMarket Evidence from the US

According to RKRV, the M/B ratio of a firm can be decomposed into three components: firm-specific error, time-series sector error, and long-run value-to-book.. In this study, we take one

Journal of Business Finance & Accounting, 39(9) & (10), 1357–1375, November/December 2012, 0306-686X

doi: 10.1111/jbfa.12000

Motives for Mergers and Acquisitions:

Ex-Post Market Evidence from the US

HIEN THU NGUYEN, KENNETH YUNG AND QIAN SUN ∗

methodologies further exacerbate debates in the extant literature This study uses a recently developed technique to examine post-acquisition evidence as to the motives behind merger and acquisition activity Using a sample of 3,520 domestic acquisitions in the United States, we find that 73% are related to market timing; 59% are related to agency motives and/or hubris; and 3% are responses to industry and economic shocks Our results also show that about 80% of the mergers in our sample involved multiple motives Thus, in general it is very difficult to have a clear picture of merger motivation because value-increasing and value-decreasing motives may coexist

1 INTRODUCTION

In 1995, completed mergers and acquisitions (M&As) among corporations in the US reached an aggregate value of US$377 billion In 2005, the amount exceeded US$1.1

illusive Event studies typically find that mergers create shareholder value over short-term windows, despite the fact that the gain predominantly accrues to shareholders

of target firms There is also ample evidence that acquirers have significant negative returns over long-term windows that overwhelm their positive short-term returns, making the net wealth effect negative (Loughran and Vijh, 1997; Rau and Vermaelen, 1998; and Andrade et al., 2001) If mergers do not create value for acquiring firms,

it is unclear what bidders intend to achieve in merger activity Research studies of non-US mergers have also reported inconclusive results on merger motivation For example, several researchers report that multiple motives may be involved in UK mergers (Hodgkinson and Partington, 2008; and Arnold and Parker, 2009) Agarwal

∗The first author is from the University of Technology, Vietnam National University, Ho Chi Minh City, Vietnam The second author is Professor of Finance at the College of Business and Public Administration, Old Dominion University, Norfolk, USA The third author is Associate Professor of Finance at the College

of Business, Kutztown University of Pennsylvania, USA (Paper received February, 2008, revised version accepted June, 2012)

Address for correspondence: Qian Sun, Associate Professor of Finance, Department of Accounting and Finance, Kutztown University of Pennsylvania, Kutztown, PA19530, USA.

e-mail: sun@kutztown.edu

1 Source: Mergers and Acquisitions Magazine Various issues.

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2013 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK

Journal of Business Finance & Accounting

and Bhattacharjea (2006) argue that corporate mergers in India are significantly related to industry shocks but unrelated to managerial motives Mehrotra et al (2011) find that merger announcements in Japan do not create wealth gains for shareholders

of either target or bidder firms

There are several potential solutions to this merger motivation quandary One solution could be achieved by examining the stated goals in M&A announcements However, it would be difficult to implement because acquirers sometimes do not announce their acquisition motives In addition, even if there is an announcement, there could be additional motives that are not announced Another solution is to

infer the underlying merger motivations from ex-post market data In other words,

we let the market tell us the motives behind the mergers A major advantage of this approach is that there is no need to rely on announcements of goals by acquirers in corporate takeovers This is particularly appealing given that some acquirers are not straightforward about their motives

Evaluating the motivation behind a merger can be a daunting task even if ex-post market data are used The empirical literature on M&As is crisscrossed with

methodologies that show differences in time frameworks (event-time vs calendar-time), abnormal return metrics, benchmarks, and weighting procedures The dif-ferences often lead to conflicting results and make comparisons difficult (Agrawal and Jaffe, 2000; and Bruner, 2002) Hodgkinson and Partington (2008) specifically report that their UK results are sensitive to whether merger gains are measured over

a long or short window and the method of measuring abnormal returns In addition, conclusions that are based on event studies could be biased because the abnormal returns of bidders could be correlated due to findings that mergers often occur in waves (Shleifer and Vishny, 2003; and Rhodes-Kropf and Viswanathan, 2004) In this study, we overcome the issue of non-comparable methodologies by using the technique

of Rhodes-Kropf et al (2005, henceforth RKRV) to detect the different motives for mergers Instead of examining the abnormal returns of acquirers, the RKRV methodology decomposes the market-to-book (M/B) ratio and makes inferences based on the characteristics of the components RKRV compared the M/B ratio components of bidders and non-bidders to infer the underlying merger motivation

We go beyond the original RKRV study and apply RKRV’s methodology to examine the M/B ratio components of bidders before and after a merger We argue that the

changes in the M/B ratio components after mergers can serve as ex-post evidence of

merger motivation

We examine a sample of 3,520 US domestic M&As in the twenty-year period between

1984 and 2004 Our results contribute to the literature in several ways First, we find that single-motive mergers are relatively less common Of the 3,520 mergers examined, 78% are related to at least two motives simultaneously Our results show that 73% of the mergers are related to market timing; 59% are related to agency motives and/or hubris; and only 3% are responses to industry and economic shocks Our results confirm the postulations of a number of researchers that mergers could involve multiple motives Our finding suggests that it is generally difficult to have

a clear picture of the underlying motivation for mergers as value-increasing and value-decreasing motives frequently coexist Second, in using the same methodology

in evaluating merger motivation, we overcome the issue of comparability across methodologies In addition, our results are reliable because the conclusions are not based on announcement period abnormal returns that are correlated across acquiring

firms in merger waves Third, our results are based on ex-post market evidence and

are consistent with reported results that are based on pre-acquisition information Lastly, we show that acquirers frequently exhibit firm characteristics that may promote multiple objectives in corporate mergers

The rest of the paper is organized as follows Section 2 is a review of the literature

on the motives for M&As Section 3 describes the methodology and our hypotheses development Section 4 describes the sample Results are presented in Section 5 and the conclusion is given in Section 6

2 LITERATURE REVIEW Acquirer motives for M&As can be classified as either value-increasing or non-value-increasing Value-increasing M&As are primarily undertaken to benefit from the synergy in combining the physical operations of the two merging firms (Bradley

et al., 1988) Various considerations drive synergistic acquisitions, including increased market power, response to industry shocks, economies of scale, financial synergy, taxes, and exploitation of the asymmetric information between the acquiring and target firms Empirical evidence on acquisitions driven by value-increasing motives is mixed Pound (1988) suggests that acquirers do not benefit from taking over undervalued targets Contradicting the market power theory, Eckbo (1985) finds competitors enjoy positive abnormal returns around acquisition announcements Although Hayn (1989) finds evidence of depreciation-related tax benefits in M&As, Auerbach and Reishus (1988) suggest that these benefits are not enough to justify mergers Supporting the operating synergy argument, Healy et al (1992) find that merged firms have

a higher level of operating efficiency Ghosh and Jain (2000) support the financial synergy arguments by showing that financial leverage increases significantly after a merger Consistent with the response to industry shock theory, Weston and Chung (1990) observe that takeovers in the 1980s were numerous in industries undergoing deregulations and fundamental changes Jensen (1993) also suggests that many mergers in the 1980s were a response to the energy price shocks during that period

Value-decreasing motives for M&As consist of three major types: agency, hubris and market timing Agency problems arise when managers consume perquisites at the expense of shareholders Other forms of agency problems arise when managers pursue excessive growth to promote personal interests (Morck et al., 1990), or diversify to reduce risk to managerial human capital (Amihud and Lev, 1981), or avoid activities that may reduce discretionary cash flows (Jensen, 1986; Stulz, 1990) The literature has ample evidence of agency problems related to M&As Malatesta (1983) finds that mergers that are probably motivated by agency problems typically are value-decreasing transactions for the acquiring firm Morck et al (1990) report that many acquirers are more interested in maximizing firm size than firm value, and that many M&As are driven by managerial objectives Shleifer and Vishny (1989) conclude that some acquisitions are made to enhance the dependence of the firm on the skills of the acquiring managers, even though such acquisitions may reduce the value of the acquiring firm

Hubris is the second type of value-decreasing motive behind M&As According to Roll (1986), many corporate managers are infected by hubris and overpay for targets Managers affected by hubris engage in acquisitions even when there is no synergy

Moeller et al (2004) show that larger firms, which are more likely to be run by hubristic managers, tend to offer higher takeover premiums and are more likely to complete a takeover than their smaller counterparts Hayward and Hambrick (1997) find that the size of acquisition premium is highly associated with indicators of CEO hubris According to Berkovitch and Narayanan (1993) and Barnes (1998), there is strong evidence that many takeovers are motivated by hubris

Market timing is another motive that results in value-decreasing M&As Shleifer and Vishny (2003) introduce a model in which overvalued acquirers use stock to buy relatively undervalued targets even though both firms could be overvalued According

to Shleifer and Vishny, acquisitions are basically stock market driven Supporting the market timing hypothesis, Dong et al (2006) find that acquirers are on average more highly overvalued than their targets; and high-valuation acquirers are more likely to use stock as the payment method In addition, acquisitions by overvalued acquirers are typically followed by lower post-merger abnormal returns RKRV (2005) introduce

a market timing model that is slightly different from that of Shleifer and Vishny and provide empirical support for the market timing motive

Some researchers have suggested that mergers may involve multiple motives For example, Donaldson and Lorsch (1983) posit that acquiring firms pursue growth to enhance their long run survival and at the same time protect acquiring managers from outside monitoring Amihud and Lev (1981) suggest that corporate diversification allows the firm to achieve more stable operating performance yet enables the firm’s manager to reduce risk to his human capital Shleifer and Vishny (1989) find evidence that some mergers are conducted to benefit the long-term growth of the acquiring firm and simultaneously improve the acquiring manager’s job security Berkovitch and Narayanan (1993) investigate synergy, hubris, and agency as motives for mergers and conclude that the three motives simultaneously exist in some takeovers Hodgkinson and Partington (2008) and Arnold and Parker (2009) examine acquisitions in the

UK and conclude that mergers may involve multiple motives Specifically, both studies report that UK mergers are probably related to synergy and market-timing motives Moreover, the lack of wealth gains during merger announcements periods in Japan is consistent with the implication that conflicting merger motivations may be involved (Mehrotra et al., 2011)

3 TRACKING THE MOTIVES FOR M&AS AND HYPOTHESIS DEVELOPMENT

In identifying merger motivation from ex-post market data, we use the methodology

developed by RKRV According to RKRV, the M/B ratio of a firm can be decomposed into three components: firm-specific error, time-series sector error, and long-run value-to-book The decomposition equation is written as:

where m and b are the market and book values of shares in logarithmic forms,

and the fundamental value implied by industry averages at time t This component

measures firm-specific pricing deviations from short-run industry pricing, and it exists when the firm is experiencing short-run irrational mispricing in the market The

implied by industry averages at time t and the firm’s fundamental value implied by

long-run industry averages This component arises when contemporaneous multiples differ from long-run multiples The component reflects that firms in the same industry

difference between the firm’s fundamental value implied by long-run industry averages and the book value of the firm According to RKRV, it is the third component that captures the long-run growth opportunities of the firm

RKRV use their model to compare the three M/B ratio components of acquirers and non-acquirers In this study, we take one step forward by investigating the changes

in the three M/B ratio components (i.e., firm-specific error, time-series sector error, and long-run value-to-book) of acquirers after merger Given that our objective is not

to identify what causes valuation errors, a negative change in the firm-specific error of the acquiring firm after a merger is sufficient to imply that the market has recognized the overvaluation of the firm’s common stock Therefore, we argue that changes in the firm-specific error are suitable for tracking the market timing motive for M&As Based

on the findings of Dong et al (2006), we posit that the firm-specific error component

of the acquiring firm’s M/B ratio will experience a negative change if market timing is the motive behind the acquisition We develop the two following hypotheses:

Hypothesis 1: In stock mergers, the firm-specific error of the acquiring firm will

experience a negative correction if market timing is the motive

Hypothesis 2: Cash acquirers will likely experience less firm-specific error

correc-tions than stock acquirers

The second component of the M/B ratio in RKRV, the time-series sector error, implies that the acquirers having this component share some temporary industry-wide valuation adjustments In merger activity, this is likely to occur when the acquirers respond to system-wide fundamental shocks and attempt to obtain some benefits Thus, we argue that changes in the second component of the M/B ratio can be used to track M&A motives that represent responses to industry and/or economic shocks

Hypothesis 3: For M&As motivated by industry and economic shocks, acquiring

firms would experience an increase in the time-series sector-wide error after the acquisitions

The last component of the M/B ratio, the run value-to-book, reflects long-term growth opportunities We argue that this component is suitable for tracking M&A motives that are related to agency, hubris and synergy We posit that acquiring firms that experience a decline in long-run value are likely to be those that suffer from managerial entrenchment For M&As that are related to hubris, however, we may observe either a decline or no change in the long-run firm value If we observe positive changes in the long-run value of the acquiring firm, then it is likely that the merger motive is synergy related

Hypothesis 4: The third component, the long-run value of the M/B ratio of the

acquiring firm, is increased (decreased) if the merger is motivated by synergy (agency or hubris)

4 THE SAMPLE Information on completed M&A deals involving publicly traded US acquirers and targets with a deal value larger than US$10 million is collected from the Thomson One Mergers and Acquisitions database for the 1984 to 2004 period The initial sample of 7,199 acquisitions includes information on announcement date, effective

date, method of payment, deal value, and proportion of acquirer’s ex-post ownership.

Stock price data are collected from the Center for Research in Securities Prices (CRSP) database Other relevant financial variables are collected from the Compustat data files, including 4-digit SIC Codes, fiscal year-end dates, and accounting data

We use the method suggested by RKRV in merging data from the three sources to take into account that firms have different fiscal year-end dates and to ensure that the price data reflect the corresponding year’s accounting information This approach

of merging the three sets of data, after eliminating those observations with missing variables or outliers, gives us a final sample of 3,520 completed merger events involving 1,973 acquiring firms We classify the firms in the sample into two groups: merger and non-merger A firm is included in the merger group in the year that the firm has a merger announcement A firm is included in the non-merger group in the years in which it has no merger activity

Table 1 reports the frequency distribution of the sampled mergers by year and payment method Of the 3,520 events, 26.70% are stock acquisitions, 40.39% are cash offers, and 32.90% are mixed payment acquisitions Cash is the dominant payment method for acquisitions before 1990; stock is used more often after 1990 The number

of stock acquisitions in the 1990s is almost twice that in the 1980s The mean deal value

in the 1990s almost doubles that in the 1980s; the median deal value increased slightly

in the 1990s

5 M/B RATIO DECOMPOSITION RESULTS The mean and median values of M/B of acquirers one year before and up to three years after merger are reported in Table 2 Firms that are involved in more than one merger are grouped together as active acquirers In Panel A, the mean M/B ratio

of all the acquirers decreases gradually from 4.01 before merger to 3.59 three years afterwards Similar declines are found for one-time and active acquirers In Panel B,

the logarithm form of M/B ratio, (m – b), shows similar changes All the declines are

significant at the 1% level, implying that mergers destroy shareholder value in general Changes in the three M/B components one, two and three years after merger are

reported in Table 3 In this study, we name these corrections to highlight the ex-post

market reaction regarding the acquiring firm’s valuation Panel A reports the market corrections of the components over the three event windows for the whole sample Panel B compares the corrections experienced by acquirers with those experienced

by non-merger firms In Panels C–G of Table 3, changes in the three components of the M/B ratio are reported, with the sample grouped according to the frequency of merger, method of payment, proportion of shares acquired, pre-merger M/B ratio, and acquirer’s market value

(i) Evidence for the Market Timing Motive

For the entire sample, the firm-specific error significantly and consistently declines

in the one, two and three years after merger Specifically, in Panel A of Table 3, the

Notes: This

Table 2

The Market-to-Book Ratio Before and After Merger

All Acquirers One-time Acquirers Active Acquirers

Panel A The M/B Ratio in Base Form

2.38∗∗∗ 1.92∗∗∗ 2.52∗∗∗

2.27∗∗∗ 1.79∗∗ 2.40∗∗∗

2.31∗∗∗ 1.74∗∗ 2.48∗∗∗

2.37∗∗∗ 1.85∗∗ 2.60∗∗∗

Panel B The M/B Ratio in Logarithmic Form, log(M) – log(B)

0.869∗∗∗ 0.651∗ 0.923∗∗∗

0.823∗∗∗ 0.580∗∗ 0.876∗∗∗

0.840∗∗∗ 0.555∗∗ 0.908∗∗

0.867∗∗∗ 0.617∗ 0.954∗∗ Notes:

This table presents the average M/B ratio of acquirers before and after merger Mean (median) values are reported in the first and second rows, respectively ∗∗∗, ∗∗ and ∗ denote significance at the 1%, 5%, and 10% levels, respectively.

firm-specific error is reduced by 0.058 in one year, 0.160 in two years, and 0.172 in three years after merger

Panel B of Table 3 shows that the corrections of the firm-specific error of acquirers are significantly larger than those of non-merger firms over the three windows On average, the correction of the firm-specific error of acquirers is 0.038 more than that

of non-merger firms in one year, 0.141 in two years, and 0.134 in three years The result

is consistent with the implication that the market has corrected its overvaluation of the acquirer’s share value relative to the fair value based on short-run industry averages The correction of the firm-specific error persists over the three event windows after merger This finding strongly supports Hypothesis 1 that market timing is a motive for acquisitions In untabulated results, Hypothesis 1 was tested by excluding finance and utility industries and similar results were found

Panel C of Table 3 shows that the firm-specific error of one-time acquirers is reduced

by 0.111 in one year, 0.166 in two years, and 0.224 in the three years after merger, and all the changes are significant at the 1% level For the active-acquirer group, firm-specific error is reduced by 0.040 in one year, 0.158 in two years, and 0.155 in three years The difference between the two groups in each window is not statistically significant An implication is that once the market has recognized its overvaluation of

an acquirer, a one-time correction is adequate and further acquisitions by the same acquirer do not lead to further valuation revisions by the market

Panel D of Table 3 provides results supporting Hypothesis 2 that stock payers suffer more firm-specific error corrections than cash payers Panel D shows that stock payers experience significant reductions in firm-specific mispricing over all the three event windows, whereas cash payers experience a significant reduction only in the first two years The corrections experienced by stock payers range from –0.070 to –0.473 and are much larger than those experienced by cash payers, which range from –0.039 to –0.046 The difference between the stock and cash payers is significant at the 1% level The result shows a strong support for Hypothesis 2 that stock payers experience larger firm-specific error corrections than cash payers, implying that market timing is a more important motive among stock acquirers

To further evaluate the market timing motive, we divide the acquirers into five quintiles based on the pre-acquisition M/B ratio and compare the correction of the firm-specific error between quintile one (value stocks) and quintile 5 (glamour stocks)

In Panel F of Table 3, the correction of the firm-specific error of glamour acquirers is 0.374 more than that of the value acquirers in one year, 0.366 in two years, and 0.438

in three years; and the difference between the two groups is significant at the 1% level

in each window The result is consistent with implications that the market considers higher-valuation acquirers more likely to have the market timing motive

We also divide the sample into five quintiles based on the pre-acquisition market value of the acquirer and report the result in Panel G of Table 3 We find that large acquirers experience larger firm-specific error corrections than small acquirers That

is, the market believes that overvaluation is more serious among glamour and/or large acquirers and therefore corrects more strongly

(ii) Evidence for the Response to Industry/Economic Shocks Motive

In Panel A of Table 3, the mean time-series sector error for the whole sample increases after merger and is significant at the 1% level for both the two and three years windows The median value is also significant in each of the three event windows The result implies that the acquiring firms experience higher levels of sector-wide valuation error after merger as the mergers are likely responses to industry/economic shocks However, in Panel B of Table 3, when compared with the non-merger firms’ time-series sector error corrections, the corrections of acquirers are not significantly different from those of the non-merger firms One possible explanation is that sector-wide errors also exist in industries that do not have industry/economic shocks; another possible reason is that the non-merger firms are able to react to sector-wide changes without going through mergers

In Table 3, an increase in time-series sector error among the acquirers is consistently found in the various sub-category analyses when the sample is sorted by the frequency

of M&A (Panel C), method of payments (Panel D), proportion of acquired shares (Panel E), pre-acquisition M/B ratio (Panel F), and acquirer’s pre-acquisition market value of shares (Panel G) The findings suggest that many M&As are driven by industry and/or economic shocks

In untabulated results, we examine the correction of time-series sector error by industry and find that about one-third of the industries show significant increases

in time-series sector error after merger The increase happens mainly in the busi-ness equipment, finance, chemicals, and consumer non-durables industries These industries experienced many price and regulatory shocks over the sample period;

T