Download A. Returns to targets

Corporate Control I
This material is a summary of the papers by M. Jensen and R. Ruback, The market for corporate control: The scientific evidence, J F
E 1983, Weston, Chung and Siu “Takeovers, Restructuring and Corporate Governance (1997) M. Bradley, A. Desai, and H. Kim, The
rationale behind interfirm tender offers: Information or synergy? Journal of Financial Economics, 11 (1983) 141-153; M. Bagnoli
and B. Lipman, Successful takeovers without exclusion, R F S (Spring 1988), 89-110, Grossman and Hart (1980), Bradley (1980) and
Bradley and ‘Kim (1984), Healy, Palepu and Ruback (1992), Franks, Harris and Tiiman (1991), Berger, Philip G. and Eli Ofek, JFE
1995, Chandler (1977), Weston (1970), Stulz (1990) Lewellen, 1971. Rumelt (1974), Jensen’s (1986), Meyer, Milgrom, and Roberts
(1992), Agency Problems, Equity Ownership, and Corporate Diversification, Amihud and Lev (1981), Denis, Denis, Sarin Journal of
Finance, 1997, Chang, 1998, Journal of Finance
The market was regarded by Adam Smith as an invisible hand that distributes
resources to its most efficient use. Private and public companies are acquired on a daily
basis. We could regard this activity as a means to control the rights to determine the
management of corporate resources. In the market for corporate control, also referred as
takeover market, alternative managerial teams compete for the right to manage corporate
resources. A recent WSJ article states that the value of the merger activity in the late 90’s
exceeded $1 trillion dollars per year.
Takeovers (I will refer to this activity with the general term of M&A) can occur
through merger, tender offer, or proxy contest, and sometimes elements of all three are
involved.
1. In mergers and tender offers the bidding firm offers to buy the common stock of
the target at prices in excess of the target’s previous market value. Mergers are
negotiated directly with target’s managers and approved by the board of directors
before going to the target’s shareholders for approval.
2. Tender offer are offers to buy shares directly from target shareholders who decide
individually whether to tender their shares.
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3. Proxy contests occur when an insurgent group, often led by a dissatisfied former
manager of a large stockholder, attempts to gain controlling seats on the board of
directors.
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Will M&A ever take place?
Before attacking the empirical evidence, let us think about the process in which
firms acquire firms from current shareholders.
Suppose that stockholders have rational expectations and that no stockholder can
affect the outcome of the takeover bid. If the bid is going to succeed, no stockholder will
sell unless he is offered at least the post-takeover value of his stock. Consequently, the
raider cannot purchase a share unless he pays at least what the share is worth to him if the
bid succeeds. The idea behind exclusionary mechanisms is that the only way to create
proper incentives for the production of a public good [i.e., guaranteeing that the firm is
efficiently run] is to exclude non-payers [minority stockholders] from enjoying the
benefits of the public good.
There are several different exclusionary devices:
1. Prior to a takeover, the shareholders voluntarily accept a dilution of their property
rights in the event of a takeover by adopting rules that allow the raider to exclude
them from some of the increase in the value of a share.
2. A second device focuses on front-loaded two-tier bids. These bids specify two
prices, the front-end and back-end prices. The raider offers to pay the front-end
price for controlling interest in the firm. If he takes over, then the minority
stockholders are forced to sell their shares for the back-end price. As long as the
back-end price is less than the value of a share under the raider’s management,
this is a form of exclusion.
3. When there is a finite number of stockholders, some stockholders must be pivotal
in the sense that they recognize they may affect the outcome. Making some
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stockholders pivotal is crucial because it forces them to choose whether or not the
bid succeeds. Hence, they cannot free ride, so exclusion is not necessary for
successful takeovers.
These views suggest that to make the target’s shareholder tender, the bidder company has
to offer a price superior to the current market price. Thus, the empirical evidence should
indicate an increase in the price of its shares when the announcement of the M&A takes
place.
Why do M&A take place?
A firm willing to expand its current production or enter in a new line of business
could develop its current capacity without acquiring another firm. There are transaction
cost in acquiring firms: Out of pocket fees to investment banks; lawyers and advisers;
time and resources expended during the acquisition period; cultural and managerial
problems or adaptation of the acquired firm to the culture and structure of the
organization. Why do firms decide to acquire another firm?
If managers are acting in the shareholders interest, we expect that bidder and
target firms should experience an increase in share value when the transaction is
announced. Value can be created because M&A are an attempt by the bidding firm to
exploit some specialized resource by gaining control of the target and implementing a
higher valued operating strategy. The revised operating strategy may involve:
1. More efficient management
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2. Economies of scale
3. Improved production techniques
4. The complementary resources
5. Increased market power
6. The redeployment of assets to more profitable uses, or any number of
value-creating mechanisms (synergies)
An alternative hypothesis of why value might be created is the release of
information during the tender process. There are two forms of this information
hypothesis:
1. The target was previously undervalued (“sitting on a gold mine” hypothesis)
2. The bidder management will implement a higher valued strategy (“kick in the
pants” hypothesis)
It could also be argued that M&A might destroy value for the bidder firm:
1. Indeed, a commonly posed motive might be to increase diversification:
Diversification can be appealing for managers and workers of the firm that seek to
preserve the organization and their reputational capital. However, this is in
contrast to the existence of a well-diversified base of shareholders who can
diversify across firms in the capital markets. We will see more about the effects
of diversification later.
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2. Also, if we think of the M&A as an action with many competitors or bidders, it is
likely that the wining bidder is paying too much (winner’s curse). In this
situation, the last bid will be in excess of the present value of the estimated cash
flows, otherwise there will be a higher bid.
3. The winner curse could result from hubris (excessive auto-confidence, pride,
arrogance) by the managers of the bidding firm. The results from hubris could be
a transfer of wealth from bidder to target firms (bidder price will decline and
target will increase).
4. Takeovers could be a solution to agency problems in the firm: If incumbent
managers do not maximize shareholders’ value, a group of outside managers
(other firm) will take over, fire them, and increase the firm’s value. However,
M&A can also be a manifestation of agency problems. Managers can be
motivated to increase firms’ size. Mangers can receive pecuniary and nonpecuniary rents if they manage a larger firm.
Agency problems, hubris and value destroying diversification are more likely if
there is abundant free-cash flow in the firm.
The question left is: do M&A’s increase or destroy value? If they do, which party, the
bidder or the target (or both equally) receives the gains? Think about the different
theories that justify M&A and make implications on value creation.
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Empirical results
These results are obtained using event study methodologies. The return is computed
as the unexpected change in prices of a large sample of M&A around the announcement
date of the event (please see the handout on event studies).
1. Returns in successful M&A
A.
Returns to targets
Around a positive 30% (20%) abnormal return in tender offers (mergers).
B.
Return to bidder firms:
In perfectly competitive capital markets we should observe only zero NPV
projects.
The results in general suggest that the return to bidders is not statistically
significant (we can not reject the null hypothesis that the abnormal return
is zero).
2. Unsuccessful takeovers.
B. Returns to targets:
If the takeover fails in an initial stage, but is taken over in a later stage (in
period of 2 months), the returns to targets are even more positive than in
successful takeovers.
If the firm is not taken over (in a period of five years), the return that was
positive around the announcement (like a successful M&A) becomes
negative after two years of remaining independent (the takeover was
unsuccessful)
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C.
Returns to bidders:
In general, the returns to bidders are not different from zero, although
there is a range of results depending on the initial response and on whether
or not the acquiring firm made a later takeover.
3. Method of payment:
A.
For target firms there is a positive abnormal return when the
bidder uses cash or equity.
B.
For bidder firms: The return is negative when stock is used as method of
payment.
The return is insignificant when cash is used.
4. Single versus multiple bids:
A.
Target firms: The positive return for target firms is more positive when
there are multiple bidders.
B.
The return to bidders is negative. The bidder that comes to rescue a firm
from a takeover is normally called “White Knight” and it seems that they
pay too much (“winners curse”?)
5. Private vs. Public Targets:
Acquirers of private targets experience zero or negative returns but acquirers of
private firms gain at the announcement of the acquisition.
6. Large versus small bidders: Large bidders experience losses at the
announcement of the acquisition, while small capitalization bidders gains at the
announcement.
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Post Merger Performance
The post merger performance is usually adjusted by changes in performance of other
firms in the same industry that did not merge.
The results are ambiguous, and depend on the sample composition, period of
study, and methodology used.
In general, it is safe to say that the empirical results so far do not show significant
improvements in performance of merging firms.
Conclusions on Empirical Evidence
In general, there is value created in M&A. Target firms experience large gains
and bidder firms show no statistically significant gains or losses. Thus, we observe a
combined creation of wealth. The sources of these gains can be synergies (although in
general we do not observe improvements in operating performance after the merger), and
information released in the acquisition process.
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Corporate Focus and Internal Capital Markets
Advantages of diversification:
1. Diversification leads to economics of scope.
2. Multidivisional firms create a level of management concerned with coordination
of specialized divisions, and they are inherently more efficient and thus more
profitable than their lines of business would be separately.
3. Firms diversify to overcome imperfections in external capital markets. If the
information asymmetry between the firm and potential investors becomes too
large, firms may decide to forego positive net present value (NPV) projects.
Diversified firms, by creating a larger internal capital market, reduce the underinvestment problem.
4. Another potential benefit of diversification arises from combining businesses with
imperfectly correlated earnings streams. This coinsurance effect gives diversified
firms greater debt capacity than single-line businesses of similar size. One way in
which increased debt capacity creates value is by increasing interest tax shields.
Thus, diversified firms are predicted to have higher leverage and lower tax
payments than their businesses would show if operated separately.
5. A further tax advantage arises from the tax code’s asymmetric treatment of gains
and losses. Note that undiversified firms are at a significant tax disadvantage
because tax is paid to the government when income is positive, but the
government does not pay the firm when income is negative. This disadvantage is
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reduced, but not eliminated, by the tax code’s carryback and carryforward
provisions.
Many authors argue, however, that related diversified firms perform better
than conglomerates argues that related diversification affects value more
positively than unrelated diversification because skills and resources can be used
in related markets. Others discuss the effects of reputation and economies of
scope, which arise when the joint cost of producing two or more outputs is less
than the sum of the costs of producing each output by itself.
Diversification can create several costs:
1. Diversified firms will invest too much in lines of business with poor investment
opportunities. This argument can lead to cross-subsidization of failing business
segments. A failing business cannot have a value below zero if operated on its
own, but can have a negative value if it is part of a conglomerate that provides
cross-subsidies.
2. Managers diversify to protect the value of their human capital.
3. Theoretically, if diversification might reduce under-investment problems, it can
also lead to over-investment. The cross-subsidization of divisions within a
conglomerate gives divisional managers easy access to capital, which may
exacerbate the agency costs of free cash flow (Jensen,1986). Proponents of
conglomerate diversification implicitly assume that managers of conglomerates
are better at monitoring the divisions than the external capital market and that
agency costs are not large enough to offset this benefit.
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Empirical Results on diversification
1. There was a steady trend toward greater focus during the 1980s and 1990s.
2. The trend toward greater focus is associated with greater shareholder wealth. This
relation is not trivial in economic magnitude
3. In general, diversification reduces value. The estimated value loss averaged 13%
to 15% over the 1986-91 sample period, occurred for firms of all sizes, and was
mitigated when the diversification was within related industries.
4. In general, over-investment is associated with lower value for diversified firms,
and segments of diversified firms over invest more than single-line businesses do.
1. There is evidence that suggests the subsidization of poorly performing segments
contributes to the value loss from diversification.
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