21st entury m&a’s and the post -merger performance …

T.J.A. Nouwen – Master Thesis 2012

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21st CENTURY M&A’s AND THE POST-MERGER

PERFORMANCE OF ACQUIRING FIRMS

MASTER THESIS

Name: Twan Nouwen ANR: 685341

Study Program: Finance Faculty: FEB

Supervisor: Dr. J. Driessen


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Table of Contents

Introduction ............................................................................3

Current State of Literature ......................................................5

History of Merger waves .......................................................5

Theories behind Merger waves ...........................................10

M&A Performance ...............................................................16

Research on Long-term Acquiring Shareholders return .......24

Data .....................................................................................24

Methodology .......................................................................26

Long-term Acquiring Shareholders return ...........................29

Interpretation of the Results ...............................................38

Conclusion ...........................................................................44

References .............................................................................45


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INTRODUCTION

This paper will primarily research the Post-Merger performance of acquiring firms. The Post-Merger

performance, i.e. one to three years after the merger, is an area where the existing literature is

divided. Malesta (1983), for instance, researched the long-term performance of M&A in the period

1969-74 for the US market using the Market Model. The results show a significant negative return for

the acquirer of -7.6 percent. On the other hand a study conducted by Frank en Harris (1989)

researched the period 1955-1972 but uses the CAPM model. This model shows a significant positive

return of 4.5 percent.

This research will built upon research from Agrawal, et al. (1992), and will analyze the post-merger

performance of acquiring firms in the 21st century. The research will analyze the performance of

acquiring firms in the long term, i.e. 3 year abnormal returns. A finding of significant abnormal

returns, i.e. under or over performance, subsequent to the merger for acquiring firms could indicate

that capital markets are inefficient. In an efficient “perfect” capital market the share prices should

reflect all present and future information about the specific corporation. Abnormal performance, in

the long run therefore suggests that the announcement return for the acquiring firm did not reflect

all relevant information at the time. Agrawal, et al. (1992), state that shareholders of acquiring firms

experience a significant loss of 10% over a five year merger period. Underperformance for acquiring

firms in the 21st century could therefore indicate that capital markets are still not efficient, if such

results are not significant than we could argue that the capital markets are becoming more efficient

over time.

As previous literature has shown, the statement whether mergers and acquisitions create value has

to be treated with caution. For instance, research has shown that target and bidding shareholders

generate very different merger returns. Overall, management should be aware that M&A strategies

alone do not create value. Like any other investment, mergers should return its opportunity costs or

more.

The field of M&A is one in which research is abundant and therefore there has been a lot of research

with respect to the success of mergers and acquisitions and on their occurrence. The supposed

occurrence of merger waves is also a point of view which had extensive research. History has shown

us that there is a likely pattern in the activity of mergers. This clustering pattern is characterized as a

wave and they occur in burst interspersed with relative inactivity (Sudi Sudarsanam (2003)). Until the

21st century, economics usually refer to 5 major waves occurred from 1900 onwards in the United

States. Increased M&A activity in the 21st century suggest the occurrence of a new wave. This paper

will also briefly examine the past merger waves.

As stated before, this research will analyze the long term return merger performance in 21st century,

and will complement the research of Agrawal, et al. (1992) to see whether the capital markets have

become more efficient over the last decades. Different subsamples will be analyzed to pinpoint the

occurrence of any under- or over-performance. The entire sample covers the period from 2000 until

2007. I used the SDC database to extract data w.r.t. the mergers and together with the WRDS

database collected the company specific monthly returns. This led to a sample of 492 friendly


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mergers, where I only have chosen the friendly mergers since they were predominant in the sample

and for consistency concerns, i.e. to avoid mixed results.

The methodology that is used in this paper is based upon the Capital Asset Pricing Model (CAPM) for

the calculation of the abnormal stock performance of acquiring shareholders. Besides the CAPM

assumptions, the realized returns are corrected with a size factor, using portfolio returns.

Furthermore, a second abnormal return measure is calculated which also corrects for momentum

trading and book-to-market value as constructed by Kenneth R. French.

The results of my analyses show a significant abnormal 3-year performance of 9.85% of the entire

sample, indicating the presence of over-performance in the long run for acquiring shareholders. This

could also indicate that share prices are on average undervalued around the merger announcement.

Previous research concluded the opposite, so caution is advised in the interpretation of the results.

The performance of the High Tech industry is also remarkable, which generates an abnormal 3-year

performance of over 25%. Since the High Tech industry is one of the largest subsamples in my

analysis, it has a significant effect on the overall performance. The analysis of different subsamples,

i.e. corporate focus, method of payment and industry performance, will be discussed from section 6

onwards.

Although Fama (1991) stated that anomalies in stock market returns occur due to incorrect risk

adjustment and risk estimation procedures, the finding of significant over-performance does provide

a somewhat new perspective on the profitability of merger performance. Agrawal, et al. (1992)

concluded the opposite of my results, with the exception of mergers in the 70’s but these were not

significant. But their research also indicated the presence of inefficient capital markets, so although

the performance measure is contradicting the overall conclusion of inefficient capital markets is still

valid at the moment.

The remainder of this paper is as follows. Sections 1-3 will give an overview of the current state of

literature where Section 1 will give a summary of the merger waves of the last 100 years, and section

2 will discuss theories that underlie the occurrence of merger waves and that underlie the

occurrence of mergers itself. Section 3 will provide insight in the merger performance researched in

previous literature. Sections 4-8 will present the empirical study of this paper where Section 4 will

outlay the data used in this paper, Section 5 will discuss the methodology used. Section 6 will give an

analysis of the results, including the subsamples and Section 7 will provide an interpretation of these

results. Finally, Section 8 will provide a summary of the research.


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CURRENT STATE OF LITERATURE

As mentioned before, the analysis on mergers and acquisitions is extensive. Some studies research

the performance of mergers on the long or short term. Some research the return for the target or

acquirer, et cetera. Besides studies on performance, considerable research is done on the occurrence

of the so-called merger waves. Different theories are developed about the factors underlying these

waves.

Besides studies on the performance of M&A’s and theories about the occurrence of merger waves,

behavioral finance has also become a topic in M&A research. For example, Spalt and Schneider

(2010) conclude in their paper that gambling attitudes of top managers are important in takeover

decision. In order to give a proper opinion about the performance of M&A in the 21st century and on

the occurrence of a possible 6th merger wave, research including topics about M&A performance,

theories concerning the occurrence of merger waves and behavioral finance will be discussed.

Currently there are different perspectives about the occurrence of merger waves, but generally the

consensus is that the US market underwent 5 major M&A waves. Extensive research has been

developed upon this topic but a conclusive explanation is not available yet. However, there seem to

be industry-specific factors that trigger the waves because different industries experience increased

M&A activity at different times (Sudi Sudarsanam (2003)).

The new century started with an economic recession due to the burst of the internet bubble and

another recession occurred due to the collapse of the private real-estate market in the US. After the

burst of the internet bubble, a possible new wave of mergers and acquisitions started and this paper

will research if this ‘wave’ is comparable to the other waves with respect to performance and some

possible underlying factors.

1. HISTORTY OF MERGER WAVES

The activity in mergers and acquisitions in the past century shows a clustering pattern. The clustering

pattern is characterized as a wave and they occur in burst interspersed with relative inactivity (Sudi

Sudarsanam (2003)). In referring to these waves, economics usually speak of 5 waves starting from

1890. Although each wave ended due to a recession or crisis, the beginning and length of the waves

is not (yet) identifiable. The first two waves are only relevant for the US market, the others waves are

more geographically dispersed. Especially in the fifth wave, where besides continental Europe and

the UK, Asia showed increased activity in mergers and acquisitions. This is perhaps due to the early

development of equity markets in the United States. This paper however will be primarily on the US

market.

1.1. Wave #1: 1893-1904

The first merger wave in the US started around 1890 during a period of economic expansion. One of

the key characteristics of this wave was the simultaneous consolidation of manufacturers within one

industry (Sudi Sudarsanam (2003)). Due to these horizontal mergers, monopolies were created in

major industries in the US. This resulted in a shift in corporate focus, leading to the disappearance of

over 1,800 companies and a change in the competitive environment. Due to the merger wave, over


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70 competitive industries were turned into monopolies. The economic expansion created increased

financial resources for corporations and according to Stigler (195)), mergers “permit a capitalization

of prospective monopoly profits and a distribution of a portion of the capitalized profit”. In order to

restrict the creation of monopolies, and therefore maintaining competitive industries, the Sherman

Antitrust Act1 was passed in 1890 to hinder mergers and acquisition that could negatively affect

competition. This should limit the creation of monopolies and cartels but it had limited impact in the

beginning due to lack of proper enforcement of the antitrust act (Stigler (1950)).

Besides the economic expansion during the first wave, other factors could also have played a role in

the spurred merger activity. First of all, at the end of the nineteenth century laws on incorporations2

were emerging which led to more protection for entrepreneurs. Before proper legislation, there was

an unlimited liability on entrepreneurial assets. Due to this, ‘ambitious’ entrepreneurs that seek for

new opportunities to expand had a greater exposure to risk. New improvements in the laws on

incorporations resulted in limited liability for entrepreneurs. Secondly, the development of the

capital market probably increased merger significantly because of more readily available capital

which is needed for mergers or acquisitions. Especially the development of New York Stock exchange

was important in this process.

In the beginning of the 20th century, the new antitrust laws where enforced better which started the

decline in merger activity. Around 1905 the US stock market crashed which resulted in a period of

economic stagnation and diminished merger activity almost completely.

1.2. Wave #2: 1910s-1929

After the economic recession of the early 1900s merger activity picked up again around 1910 during

times of economic recovery. Its primary focus was on the food, paper, printing and iron industry but

its magnitude is significantly smaller than the first wave. The first merger wave exceeded more than

15% of the asset base in the US, the second wave only had an impact of less that 10% of the

economy’s assets (Sudi Sudarsanam (2003)).

Due to the better enforced antitrust laws, the second merger wave led the creation of oligopolies.

The industries were no longer dominated by one large company, but rather by two or more.

Especially smaller companies were involved in merger activity in order for them to gain economies of

scale to be better equipped to the monopoly ‘giants’ created in the previous wave. The monopolists

of the previous waves were faced with restricted resources due to the recession and together with

the antitrust laws changed industries competitive structure from monopoly to oligopoly (Stigler

(1950)).

Similar to the first wave the character of the mergers in the second wave was ‘friendly’, i.e. target

management was behind the acquirer offer. Different from the first wave was the prevalent source

of financing; it converted from cash to equity financing.

The market crash of 1929 started the ‘Great Depression’ which caused a world-wide depression in

the following years. This depression diminished the merger activity significantly and caused the end

of the second merger wave.

1 Sherman Antitrust Act: restriction of entity combinations that will unlawfully limits competition.

2 Incorporate: combined into one united body; casu quo: merged.


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1.3. Wave #3: 1955-1975

After the ‘Great Depression’ and the following World War II the merger activity slowly increased

again. From the 1950s onwards further restrictions on mergers that deter the competitive

environment were put into place. This resulted in the occurrence of the third merger wave and the

creation of a new business organization. Whilst the first and second wave were dominated

respectively by horizontal and vertical integration, the third wave introduced a new concept;

diversification.

In finance diversification entails the investment in a variety of assets to reduce its risk exposure. With

diversification a corporation, or investor, can reduce its idiosyncratic risk and therefore reduce its

volatility. The diversification process leads to the creation of conglomerates, which are larger entities

that consists of many business units not necessarily related. The creation of conglomerates is a way

of reducing the cash flow volatility of a corporation because it results in less exposure to industry

specific risk. Shocks in one industry will therefore be offset be other, perhaps unrelated, industries.

Another advantage of conglomerates is the presence of an internal capital market which reduces the

dependency on outside capital. The use of internal funds is also preferable according to the pecking

order theory. The theory argues that corporations should first make use of their internal funds

before going to the capital market. Another characteristic of diversification is that it leads to

increased distance between top management and divisional management. This can lead to

inefficiencies due to increased communication lines, and the possibility of decision overload at the

company headquarters due to the presence of numerous, perhaps unrelated, businesses (Chandler

(1991)).

The creation of conglomerates due to diversification resulted in changes in the market structure.

According to the Multidivisional Enterprise concept of Chandler (1991) “structure follows strategy

and the most complex type of structure is the result of concatenation of several basis strategies”.

This means that the strategy a corporations pursues influences the structure of the market. In the

third merger wave the percentage of corporations competing in unrelated businesses increased from

9% to 21% among the Fortune 500 companies (Sudi Sudarsanam (2003)). This suggests that the

concept of diversification plays an important role in the third merger wave.

The prevalent source of financing in the third wave was equity, comparable to the second wave. At

the end of the 1970s the merger activity slowed down and collapsed in 1981 due to an economic

recession caused by a significant oil crisis.

1.4. Wave #4: 1984-1989

In the 80s the fourth merger wave started and was quite different from its previous ones. As

opposed to the other wave the bids were primarily hostile, i.e. did not had target’s management

approval. Second, the prevalent source of financing switched to debt financing and the target size

was also significantly larger than in the previous waves.

The beginning of the wave was triggered by bargain hunting of corporations in a depressed stock

market (Ravenscraft (1987)). The conglomerates created in the previous wave were divested due to

apparent inefficiency and restricted resources due to the declined stock market. According to Sudi

Sudarsanom (2003) in the fourth wave 20-40% of all M&A activity was related to divestitures and


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apparently there was a simultaneous expansion and downsizing of businesses. The expanding

corporations reinforced their competitive position though usage of opportunities provided by the

divesting conglomerates (Sudi Sudarsanam (2003)).

Besides the bargain hunting of divested parts of the conglomerate the fourth wave is according to

Schleifer and Vishny (1991) also characterized by ‘bust-up’ takeovers. This means that large parts of

the target are divested after acquiring. When we relate this to the arguments of Ravenscraft,

corporations buy divested parts of the inefficient conglomerate and thereafter divest large parts of

the target which should preferably result in an efficient business unit.

During the fourth merger wave another concept emerged; the leveraged buy-out (LBO). An LBO is

usually set up by the firms’ own management and they use large amounts of debt capital to acquire

their company. It is not unlikely that these companies were part of a larger conglomerate and

because of inefficiency issues the management might think to perform better when working

independent. Comparable with the bust-up takeovers, large parts of the LBO companies were

divested in order to offset the large debt obligations.

The inefficiencies that were created in the third merger wave started to be eliminated in the fourth

wave due to the bust-takeovers and leverage buy-outs, among others. Morck, Schleifer and Vishny

(1990) state that in the 1980s a bid on a target firm competing in the same industry is positively

related with the stock market return for the shareholders of the bidding firm. The opposite holds for

bids on unrelated targets. Apparently there was a negative attitude towards unrelated

diversification.

The M&A market slowed down gradually after 1989 and another stock market crash ended the wave.

1.5. Wave #5: 1993-2000

In the 90s the financial markets were booming and there was great economic prosperity.

Globalization was the new corporate focus which increased the cross-border acquisitions

significantly. Merger activity was more geographically dispersed, resulting in a European M&A

market which almost equaled the US merger market. To make best use of the global opportunities

and to keep up with economic growth organizations looked outside their domestic borders to find a

target company. The new wave created some ‘mega’ deals that include for example: Citibank and

Travelers, Chrysler and Daimler Benz, Exxon and Mobil, et cetera.

According to Sudi Sudarsanam (2003) the fifth wave was triggered due to technological innovations,

i.e. information technology, and a refocus of corporations on their core competences to gain

competitive advantage. Corporations now focused again on their core competences to gain a

sustainable competitive advantage.

In the fifth wave the mergers were predominantly friendly again, and equity financing was the

prevalent form of financing. At the beginning of the new century the ‘internet bubble’ burst which

cause global stock markets to crash and ended the fifth merger wave.


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1.6. M&A waves summarized

The above review about the merger waves from the past century describes the evolution of M&A

activity in the US. It seems to be that the waves begin during an economic boom or recovery and a

strong increasing stock market. This is according to Sudi Sudarsanam (2003) underlying the first three

merger waves. Although the fourth and fifth wave also occurred during good economic times the

underlying factor was according to Jovanovic and Rousseau (2002) due to increased enforcement of

anti-trust laws and technological innovations which led to the redeployment of assets. Sudi

Sudarsanam (2003) reinforces this by stating that M&A waves are accompanied with high economic

growth, technological innovations, recovery from economic recession and a rising stock market. The

ending of the waves coincides with the occurrence of an economic recession usually preceded by a

stock market crash. Another notable point is the change in corporate focus and strategy in the

different waves. The first wave is characterized by the creation of monopolies whilst the second

wave transfers the industry structure from monopoly to oligopoly. In the third merger wave a new

concept of diversification rises, but is not very long lasting since the fourth wave eliminates the

inefficiencies created by the conglomerates. In the fifth wave globalization was the prevailing

corporate strategy/focus but had limited effect on industry structure. There seem to be a

relationship between the occurrence of the merger waves and the corporate focus. Does corporate

focus or strategy leads to the occurrence of a merger wave or vice versa? According to the

Multidivisional Enterprise concept of Chandler (1991) it is the former.

Table 1.1 - Summary table of the merger waves in US history.

Wave # 1 Wave # 2 Wave # 3 Wave # 4 Wave # 5

Period 1893-1904 1910s-1929 1955-1975 1984-1989 1993-2000

Predominant means of payment

Cash Equity Equity Cash / Debt Equity

M&A outcome

creation of monopolies

creation of oligopolies

Diversification / conglomerate building

‘bust-up' takeovers; LBO

Globalization

Predominant nature of M&A

Friendly Friendly Friendly Hostile Friendly

Beginning of wave

Economic expansion; new laws on incorporations; technological innovation.

Economic recovery; better enforcement of antitrust laws.

Strengthening laws on anti-competitive M&A's; Economic recovery after WW 2.

Deregulation of financial sector; Economic recovery.

Strong economic growth; Deregulation and privatization.

End of wave Stock market crash; First World War.

The Great Depression.

Market crash due to an oil crisis.

Stock market crash.

Burst of the internet bubble; 9/11 terrorist attack.


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2. THEORIES BEHIND MERGER WAVE OCCURENCE

The debate on the occurrence of merger waves is still without a conclusive explanation. Some claim

that the occurrence of waves depends on the economic climate while others claim that managerial

behavior is the most important factor underlying the merger waves. The different theories can be

categorized into three groups: (1) changes / shocks in the business environment; (2) behavioral

finance; (3) market timing.

The first group explains the occurrence of merger waves as a reaction to changes or shocks in the

business environment like an economic boom or changed regulation on competition. The second

group relates merger waves with managerial and investor behavior, arguing that managers make

irrational decisions and act out of self-interest which influences takeover decisions and advocates

limits on market arbitrage. The third group suggests that market timing is the underlying of merger

waves, relating it to the development of the capital markets.

2.1. Business environment changes

According to Martynova and Renneboog (2008) there are economic factors that trigger firms to

restructure as a response to changes in the business environment. An economic boom could provide

corporations with resources to undertake an M&A project as a response to for example a changed

corporate focus to diversification. Or changed regulation on competition could lead to the

convergence from a monopoly to an oligopoly structure. The economic disturbances model from

Gort (1969) argues that M&A activity is influenced by the presence of a disagreement on the value of

corporations. He states that economic disturbances create discrepancies in valuations about the true

value of the target. Increased merger activity will therefore arise when economic disturbances, i.e.

dramatic changes in economic factors, create these discrepancies in valuation. To test his theory,

Gort conducting an industry analysis on the US market from 1951 till 1959. According to these

results, economic growth and capital market conditions have a positive relationship on merger

activity.

Lambrecht (2004) relates the occurrence of merger waves to the development of product markets.

The research shows that there is a positive relation between mergers, driven by economies of scale,

and product market demand. According to Lambrecht, corporations searching for economies of scale

undertake mergers in rising product markets. The clustering pattern of mergers and acquisitions

could therefore be related to the cyclical pattern of product markets.

At an industry specific level, Maksimovic and Phillips (2001) argue that efficient firms are more likely

to acquire less efficient ones when the industry undergoes a positive demand shock. The increase in

demand could therefore persuade efficient, probably financially unconstrained, corporations to

invest in mergers in order to make best use of the opportunities provided by the change in the

business environment. Another research conducted on industry level by Mitchell and Mulherin

(1996) for the US market from 1982 till 1989 state that M&A’s are the most cost-efficient way to

respond to economic shocks, i.e. any factor expected or unexpected that alters the industry

structure. According to Mitchell and Mulherin (1996) a merger is the best way of coping with a

changed industry and they state that the fourth merger wave is not about eliminating the inefficiency

of the conglomerate wave but a reaction to a changing industry. This reaction to a changing industry

results in the divestitures of conglomerates. Andrade and Stafford (2004) complement the analysis


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on industry level and argue that merger activity is partly due to industry level shocks and partly due

to firm specific factors. They also state that the fourth wave is a response to changes in the industry

structure but according to them the fifth wave is the result of strategic and synergistic factors, i.e.

growth.

Besides economic changes affecting merger activity, the Q-theory of Mergers of Jovanovic and

Rousseau (2002) argues that technological changes affect merger activity. The model argues that

technological change together with the rate of investment should increase with the incremental Q.

The Q of a firm is the ratio between the market value and the replacement cost of capital. An

increase in a firms Q should therefore lead to increased investments. Decreased replacement costs of

capital, as a result of technological changes, should therefore be positively related to increased

investments. Jovanovic and Rousseau (2002) argue that during merger waves the Q is more

dispersed between corporations. The merger waves are according to them a response to profitable

reallocation, only wave three does not seem to show the same relationship. These reallocation

opportunities were caused by technological changes. According to Martynova and Renneboog (2008)

electricity and the internal combustion engine are the investment opportunities related to

respectively the first and second wave. The development of the microprocessors and the

improvement of information technology are related to respectively wave four and five.

Other research focuses more on the financial side of the corporations. There are a number of studies

that stretches the importance of financial flexibility in the occurrence of merger waves. The liquidity

created through increased cash buffers plays a strategic role in imperfect capital markets deriving

from asymmetric information (Hartford (1999)). Harford (1999) conducted a study for the US market

from 1950 till 1994 and concluded that cash-rich firms are more likely to undertake mergers and

acquisitions. These large cash buffers will be most likely created during times of economic and capital

market growth and will therefore also be clustered in these periods. In another study Hartford (2005)

researched whether market timing or industry shocks are underlying merger waves. The study

concludes that the existence of a significant shock and large cash reserves are a prerequisite for

merger waves to arise.

2.2. Behavioral Finance

Another viewpoint explaining the occurrence of merger waves is managerial behavior and decision

making. Martynova van Renneboog (2008) state that agency problems and overconfidence of

managers influences takeover decisions. Managerial behavior as an explanation for merger waves

falls in the field of behavioral finance. This field tries to explain economic and stock market

phenomena with the use of psychology based theories. Behavioral finance considers the efficient

hypothesis about capital markets to be invalid. Furthermore, besides management behavior,

behavioral finance advocates the presence of so-called market arbitrage caused by inefficient capital

markets and irrational investors.

In history, empirical and theoretical research on finance disregarded any human factors of influence

on the decision making process. The consensus existed that the judgment of individual investors was

not flawless but the overall opinion was that rational arbitrage results in efficient capital markets. In

his book A Random Walk Down Wall Street, Burton Malkiel (1973) advocates that the capital markets

follow a random walk. This random walk argues that stock prices cannot be predicted systematically

and that markets are efficient, i.e. stock prices rationally and accurately reflect all publicly available


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information. Van de Sar (2004) adds that the traditional finance approach assumes a rational agent

and the property of the optimal decision making. The Efficient Market Hypotheses (EMH) advocates

that not fully rational agents will be arbitraged away.

In recent history a new approach has been developed that corrects the traditional view on finance:

i.e. Behavioral Finance. In Behavioral Finance issues are resolved, or explained, with the influence of

psychology. Research on Behavioral Finance casts some doubt on the theory of efficient markets and

its foundations, i.e. expected utility maximization and rational expectations. Together with the

Prospect Theory, heuristics, framing and other psychological concepts, Behavioral Finance tries to

explain anomalies in economic behavior and in stocks returns.

2.2.1. Behavioral Finance

The paper of Baker, Ruback and Wurgler (2004) provides a behavioral finance survey and is a good

building block for my analysis. Their survey focuses on corporate finance, i.e. area that tries to

explain financial contracts and investment behavior which is the result of managers and investors

interaction. According to Baker, Ruback and Wurgler (2004) the behavioral approach can help to

explain numerous financing and investment patterns. In their analysis they replace the rationality

assumption with behavioral assumptions and divide the field of Behavioral Finance into two

perspectives:

1. Investor behavior is not fully rational;

2. Managerial behavior is not fully rational.

The ‘irrational’ investor approach assumes that market arbitrage is not adequate, resulting in the

mispricing of stocks. The ‘irrational’ managers’ approach assumes the presence of behavioral biases.

Both perspectives are not mutually exclusive.

Irrational investor

This approach assumes that there are limits on market arbitrage, therefore assuming market

inefficiency. Furthermore, the approach assumes ‘smart’ managers, meaning that managers must be

able to identify mispricing (Baker, Ruback and Wurgler (2004)). Reasons for the presence of smart

managers are according to them:

1. Managers have superior information concerning their own corporation. Furthermore,

Muelbroek (1992) stated that managers earn significant high returns on their own share

investments;

2. Corporate managers are less constrained than their duplicate money managers. Corporate

managers are judged over longer horizons, meaning that they can better evaluate potential

market mispricing (Baker, Ruback and Wurgler (2004)). Due to the short horizon of money

managers they are unable to duplicate the corporate managers behavior;

3. Apparently managers intuitively follow rules of thumb. Baker and Stein (2004) indicate that

one such rule of thumb is issuing equity when the market is liquid, i.e. presence of a more

than average trading frequency. A liquid market suggests the dominance of irrational

investors which could indicate overvaluation.


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The utilization of the arbitrage created by irrational investors depends on the goals/horizon the

smart managers prefer. According to Baker, Ruback and Wurgler (2004) the manager has three goals;

(1) managers try to maximize the fundamental value of the corporation with actions that increase

the present value of future cash flows. (2) Managers try to maximize the current (short-term) share

price3. (3) Managers try to maximize value for the long-term investors with market timing. It is

dependent on the managers’ horizon which goal is the most important and therefore determines

how a manager utilizes the opportunities created by imperfect market arbitrage.

What are the consequences of the market inefficiency caused by investors’ irrationality and what is

the effect on real investments and mergers and acquisitions? Polk and Sapienza (2004) argue that

investments are more sensitive to mispricing when the horizons of managers and shareholders are

short. According to Baker et al (2003) previous research suggests that stock prices influence the

investment behavior partly due to mispricing although the actual magnitude is unknown.

As said before, the mispricing can lead to significant under- and overvaluation, which according to

Schleifer and Vishny (2003) results in the market timing of acquisitions. In a previous section I stated

that market timing could be underlying the occurrence of merger waves. As stated before, Schleifer

and Vishny (2003) argue that overvalued acquirers undergo takeover investments to preserve the

(temporary) overvaluation. This assumes that behavioral biases creating mispricing results in merger

activity.

Baker, Ruback and Wurgler (2004) conclude that when the irrationality of investors holds, the

maximum economic efficiency in the long term requires the shielding of managers form short term

share price pressures. This is essential for making decisions perceived as unpopular by the market.

Irrational managers

This approach assumes the presence of efficient capital markets and irrational managers, i.e.

behavior that deviates from the concepts of rational expectations and expected utility maximization.

According to Baker, Ruback and Wurgler (2004) corporate governance should be limited in order for

irrational managers to have an impact. Usually, corporate governance should assure rational decision

making of managers. Literature on managerial behavior is extensive and not all will be discussed. It is

suffice to state that according to Baker, Ruback and Wurgler (2004) managers do not always form

beliefs logically and they are not able to convert these beliefs into decision in a logical and rational

way. Optimism and overconfidence have been the main topics in management behavioral research.

This optimism is tested by Weinstein (1980) who stated that people tend to believe that they are

more likely to experience positive events and less likely to experience negative events. Svenson

(1981) studied overconfidence of people and reported that 82% of the sample considered

themselves to be at the top 30% with respect to driving safety. This overconfidence leads according

to Baker, Ruback and Wurgler (1984) to increased risk-taking.

So, what are the consequences of irrational managerial behavior on investments and on mergers and

acquisitions? Overconfidence and optimism has an influence on the prospects of start-up firms for

instance. According to Cooper, Woo and Dunkelberg (1998) 68% of the entrepreneurs believe that

their start-up is more likely to succeed then corporations similar to theirs. In practice only 50% of all

3 In a prefect market the first two goals should be the same goals because share prices in an efficient market

would reflect the present value of all future cash flow.


14

start-ups will survive more than three years (Scarpetta, Hemmings, Tressel and Woo (2002)). Due to

overconfidence and optimism entrepreneurs therefore are more likely to invest in a start-up firm

which is not always justifiable.

The influence of irrational managerial behavior on M&A investments is explained by Roll (1980) and

his hubris theory. The hubris theory argues that overconfident managers overestimate possible

synergies and believe that they can manage the target company better. The irrational managers’

approach could therefore be an underlying for the occurrence of merger waves. Another study

conducted by Schneider and Spalt (2010) researched the influence of gambling attitudes on takeover

decisions. The paper states that gambling attitudes of top managers can create biases in M&A

pricing. Gambling driven acquisitions seem to have a significantly destroying effect for acquiring

shareholders. This suggests that the biases created by the gambling attitudes leads to high takeover

premiums. Furthermore, Schneider and Spalt (2010) argue that the probability weighting is

important for the decision making process of (gambling) biased managers. The gambling probability

depends on: whether the managers are entrenched, the presence of a young acquiring CEO, a weak

product-market competition, economic downturns and poor past performance.

2.2.2. Momentum trading

Another behavioral factor that influences stock prices, and could therefore bias investment decisions,

is momentum trading. Momentum refers to the price and volume movement of securities.

Therefore, momentum traders are seeking stocks with high volume trade and a significant moving

direction. When such stock is located, the momentum trader holds the stocks for a period of time to

maximize the profit of the momentum. According to Menkhoff and Schmeling (2006) momentum

investment strategies contradict standard finance theories due to the high returns that are not

explained by the conventional risk factors. Momentum trading therefore gives another perspective

on the efficiency on capital markets. When such ‘simple’ strategies seem to gain high returns, market

arbitrage is not efficient and therefore stock prices can be biased.

2.2.3. SUMMARY

In explaining the occurrence of merger waves, agency problems have been pointed out as an

important factor in numerous studies. Agency problems arise when there is a conflict of interest

between the agent (i.e. manager) and the principal (i.e. shareholder)(Jensen (1986)). According to

Jensen (1986) these agency problems can arise due to the existence of large free cash flows4 that are

available to management. These large amounts of cash flow provide managers with incentives to

grow above their optimal size. According to Murphy (1985) managers perceive growth as a way to

increase their power (additional resources under control) and they associate growth with increased

compensation. If the use of the free cash flows leads to growth beyond the optimal size a conflict will

arise between management and shareholders. According to Jensen (1986) these agency problems

arise during times of booming capital markets or due to industrial shocks creating the M&A waves.

Schleifer and Vishny (1991) connect the concept of free cash flow to unrelated diversification. They

state that access to free cash flow creates incentives for managers to invest in unrelated

diversification. The investments in unrelated diversification will lead to negative performance for the

4 Free cash flow: excess of cash flow that is needed to undergo all net present value investments (Jensen

(1986)).


15

acquiring shareholders in the long run. According to Schleifer and Vishny (1991) this ‘empire building’

is a key factor in explaining the occurrence of the third merger wave and the fourth wave is just a

reversal of the conglomerate wave.

Amihud and Lev (1981) also studied the third merger wave and the relationship with agency

problems. They state that risk reduction incentives lead to conglomerate building. Diversification will

lower the earnings volatility but it does not add value to the acquiring shareholders because they can

duplicate the merger investment with a ‘homemade’ portfolio. Despite the lack of value for the

acquiring shareholders, managers still have incentives to investment in M&A because it also reduces

the employment risk5. Summarizing the influence of agency problems on merger activity; the

presence of large amounts of free cash flow, the concept of ‘empire’ building (i.e. diversification) and

risk reduction creates incentives that could explain the occurrence of merger waves especially the

occurrence of the third wave. Although these agency problems seem to influence M&A activity at

some level, Jensen (1986) also states that the clustering pattern of the merger waves is triggered by

flourishing capital markets or industrial shocks that create the built-up of large free cash flow

reserves.

As said before, managerial behavior and decision making is apart from agency problems also

influenced by overconfident managers and ‘following’ behavior of other managers. Roll (1986) state

that ‘overconfident’ managers overstate the synergies created with mergers resulting in unrealistic

takeover premiums. The paper introduces the ‘hubris’ hypotheses which suggest that managers

hubris, i.e. arrogance of overconfidence, is underlying the occurrence of takeovers and takeover

waves. The managerial hubris creates a belief with management that they can manage the target

firms more efficiently resulting in inflated takeover premiums. Another behavioral theory about

factors influencing managers’ investment decision is the concept herding. This theory explains that

managers only mimic other managers’ investment decisions, neglecting their own private

information (Scharfstein and Stein (1990)). In his essay The General Theory (1936, pages 157-58),

John Maynard Keynes argues that managers follow the herd when they believe their investment

decision behavior is closely monitored by others. According to Scharfstein and Stein (1990) herd

behavior will exist due to reputational incentives and managers confrontation with unpredictable

investment outcomes. The unpredictability of the investment outcome creates a ‘sharing-the-blame’

effect meaning that managers will mimic investment behavior and in case of bad investment

outcomes will ‘share the blame’.

Combining the hubris hypothesis with the concept of herding could therefore be an explanation for

the clustering pattern of M&A’s. Martynova and Renneboog (2008) argue that the presence of

successful mergers will create mimicking behavior of other corporations and therefore increase

merger activity.

5 Employment risk: largely un-diversifiable risk. For example the professional reputation, risk of losing job, et

cetera (Amihud and Lev (1981).


16

2.3. Market timing

The concept of market timing assumes that the clustering pattern of mergers and acquisitions is due

to the overvaluation of stocks during times of financial boom (Schleifer and Vishny (2003)). This

overvaluation fluctuates between corporations and this result in opportunities for acquiring

companies to takeover less overvalued companies using their own overvalued equity. Myers and

Majluf (1984) state that managers make use of the opportunities given, due to the overvaluation of

equity during times of financial boom.

The model of Schleifer and Vishny (2003) assumes that target management maximizes their short-

term private benefits which could explain the willingness to accept an all-equity bid even if this is not

beneficial for the long-term oriented investor of the target firm. Schleifer and Vishny (2003) argue

that merger activity is linked to the fluctuating stock market. Management of acquiring, i.e.

overvalued, companies take advantage of the opportunity given by the created market inefficiencies.

Apart from theoretical models about market timing numerous empirical studies have been

developed. Dong et al (2006) confirms the theory that the stock market is a driver behind M&A

activity. The study uses residual income-to-market ratio to measure overvaluation and the findings

are that acquirers are on average more overvalued than the targets. Overvaluation is most likely to

occur in times of financial boom so the market timing concept could explain (at least some of) the

merger waves.

3. M&A PERFORMANCE

This section will give an overview of studies reporting the performance, i.e. profitablilty, of mergers

and acquisitions. Existing literature shows a great deal of dispersion in M&A performance, this

depends largely on the subject you are evaluating the performance on and how you are evaluating

performance, i.e. which benchmark return do you use. The performance evaluation can be from the

perspective of shareholders from bidding or acquiring corporations. One can also evaluate the effect

of mergers and acquisitions on other stakeholders like creditors, suppliers, employees, et cetera.

According to Martynova and Renneboog (2008) the shareholders wealth is usually the primary

objective since they are the residual owners of the corporation and the impact of takeovers on other

stakeholders is usually difficult to assess. This review will therefore be focused on the perfromance of

target and acquirer shareholders. The method that is used and the benchmark that is chosen also

influences the results. There are different methods to assess the success of M&A; there are

accounting studies, surveys of executives, event studies, et cetera. Accounting studies look at the

reported financial statements and they test the success of M&A’s by looking for example at net

income, return on equity and earnings per share. Event studies examine the abnormal return around

an M&A announcement for the acquiring or target shareholder. The event studies are predominantly

used in analyzing the performance, i.e. success, of mergers and acquisition. A (short-term) event

study assumes that during an M&A announcement the market will incorporate this new information

with the new expectations and reflect this into the share price (Martynova and Renneboog (2008)).

As a performance measure the abnormal return is used. The abnormal return is the difference

between the realized and expected benchmark return. The long-term event study uses the same

methodology but a major shortcoming is the difficulty of measuring takeover effects over longer

periods. Most often asset pricing models are used for calculating the benchmark returns.


17

An advantage of using market returns in assessing M&A performance is that it gives a direct measure

of value creation or destruction for shareholders. Furthermore, share prices are forward looking

because in theory they should reflect the present value of all future cash flows. A disadvantage of

using market based benchmark returns in the calculation of abnormal returns is the requirement of

significant assumptions about the stock market. Furthermore, this approach assumes the presence of

efficient capital markets which is something that is debatable. This review will be focused on event

studies because of its predominance and the direct measure of performance it provides. The tables

3.1-3.4 provide an overview of studies for respectively the combined shareholders, target

shareholders, acquiring shareholders and long term acquiring shareholders. The following of this

section will provide more depth about the performance of mergers and acquisitions for target

shareholders, acquiring shareholders and the long term performance of mergers and acquisitions for

acquiring shareholders. Furthermore, the performance of conglomerate deals will also be discussed

briefly.

3.1. Short-term M&A performance

The short term performance of mergers and acquisitions is according to the majority of studies

positive for the target and acquiring shareholders combined. A study conducted by Franks et al

(1991) shows a positive significant cumulative average abnormal return (CAAR) of 3.9% surrounding

the announcement return. Mulherin and Boone (2000) show a similar CAAR of 3.56%. Both studies

use a market model for the benchmark returns.

3.1.1. Target shareholders short term performance

The majority of studies indicate that target shareholder returns increase surrounding the

announcement date. According to Schwert (1996) there even seems to be a price reaction before the

announcement date for some mergers. The research indicates that there is a run-up premium of

11.90% on average, over a period of one month before the announcement date. This suggest that

the bid is anticipated which raises suspicion of insider trading or information leakages. Studies

evaluating the announcement returns for mergers and acquisitions also indicate that the returns for

target shareholders are positive. A study conducted by Eckbo (1983) shows a significant positive

abnormal return of 6.24% at the announcement date. The results of Andrade et al (2000) are similar,

showing a significant positive abnormal return of 16%.

Besides positive abnormal returns before and at the announcement date there also seem to be

abnormal performance for target shareholders one month after announcement or until completion.

Malatesta (1983) researched the abnormal performance twenty days after the announcement and

argues that target shareholders earn a significant positive CAAR of 16.8%. However the attitude

towards the deal greatly influences the significance, meaning that target shareholders confronted

with a hostile bid receive larger premium than friendly bid. Servaes (1991) reported that hostile bids

lead to significant CAAR’s of almost 32% whilst friendly bids result in CAAR’s of almost 22%. The

negative reaction of management on the notification of the bid will possibly create the consensus

that the bid will be increased leading to increasing share prices (Martynova and Renneboog (2008)).

Schwert (1996) also researched whether there is a difference in performance between tender offers

and mergers and resulted that tender offers generate substantially larger premiums. The study

reported significant announcement returns of 20.10% for tender offers and 4.90% for mergers. A

characteristic of tender offers is that they are usually paid in cash whilst mergers are usually paid in


18

stocks, so one could also assume that the method of payment influences the return for target

shareholders. This is also confirmed by previous research done by Franks et al (1991) for example.

The study reports that cash bids result in CAAR’s of 33.78% around the announcement date whilst

stock bids result in CAAR’s of 22.88%.

Research has shown that target shareholders in mergers and acquisition are most likely to profit

from takeovers. This can be prior to the announcement, at the announcement or one month after

the announcement. The majority of the studies show that target management accumulates

significant positive CAAR’s but this also depends on the attitude towards the deal and the method of

payment.

3.1.2. Acquiring shareholders short term performance

Research has shown us that target shareholders earn significant returns due to takeovers. The story

for acquiring shareholders is quite different. Acquiring shareholders return is almost negligible

around the announcement return and in most studies not significantly different from zero. The one

month run-up premium that Schwert (1996) found for target shareholders does not hold for

acquiring shareholders. The run-up premium for the acquiring part of the deal is only 1.4% and not

significant. The announcement date returns for acquiring shareholders do not paint a different

picture. Research done by Eckbo (1983) and Andrade et al (2001) which did find significant positive

returns for target shareholders resulted that acquiring shareholders announcement return was

below 1% and insignificant. Schwert (1996) does report that there is a difference between tender

offers and mergers, where tender offers generate positive announcement returns for acquiring

shareholders and mergers generate negative announcement returns but these are not significantly

different from zero.

The abnormal returns over a period of one month after the announcement date (or until completion)

do seem to be significantly different zero but this depends on the attitude towards the deal and the

method of payment. Servaes (1991) reported that hostile bids result in a decrease in value of around

4% for acquiring shareholders. As said, the method of payment also influences the abnormal returns

one month after the announcement date. According to Andrade et al (2001) mergers paid for in stock

result in a significant CAAR of -1.5. Mergers paid for in cash show slightly positive CAAR’s but these

are not significant. Acquiring shareholders apparently do not gain abnormal returns before and at

the announcement date of a takeover. However, mergers paid for in stocks seem to decrease the

value of the firm one month after the announcement (or until completion) for acquiring

shareholders.

3.2. Long term performance

The long term performance of mergers and acquisitions is difficult to assess because of problems

with incorporating all takeover effects over a longer period. This difficulty to incorporate all takeover

effects in the years subsequent to the M&A can create methodology problems. According to

Martynova and Renneboog (2008) the methodology used to predict the benchmark therefore affects

the reported M&A performance. Although the usage of different methodologies, the majority of

studies seem to indicate that acquiring shareholders show underperformance one to five years after

the takeover. Malatesta (1983) reports a significant CAAR of -7.6% three years after merger

completion (using a market model for the benchmark return). Agrawal et al (1992) also researched


19

the post acquisition performance for acquiring shareholders. They investigated a five year post

acquisition period using a benchmark model adjusted for size and beta. The study reports a

significant CAAR of -10.26%. According to Agrawal et al (1992) this finding of underperformance has

three major implications:

I. The concept of efficient capital market becomes questionable;

II. Studies examining announcement returns implicitly assume efficient capital market.

Therefore all these studies can be incorrect;

III. A finding of underperformance can support studies reporting poor accounting performance

after takeovers.

Loughran and Vijh (1997) researched the long term shareholder performance and potential

difference between the methods of payment and the acquisition type. A five year post acquisition

period was used with a benchmark return corrected for size and book-to-market ratio. The study

argued that tender offers perform better than mergers and mergers paid for in stock perform better

than mergers paid for in stock. The results report significant positive CAAR’s of 56.2% and 33.9% for

respectively tender offers and mergers paid for in cash. Mergers paid for in stock show CAAR’s of -5.9

but are not statistically significant. Loughran and Vijh (1997) state that long term wealth gains are

higher for tender offers because they are usually hostile. This suggests that the market perceives the

acquiring management to perform better than target management. Furthermore, the research states

that acquiring management will chose stock payment when they believe their share price is

overvalued. The overvaluation of stock is only corrected years after the takeover, suggesting that the

capital market is not efficient.

The study conducted by Rau and Vermaelen (1998) investigates the long term performance for

acquiring shareholders in relation to ‘glamour’ corporations, i.e. corporations with low book-to-

market ratio. First of all, the study argues that there is an underperformance 3 years after merger

completion. However, the underperformance is according to Rau and Vermaelen (1998)

predominantly caused by ‘glamour acquirers’. Apparently low book-to-market firms make poor

acquisition decisions. Rau and Vermaelen (1998) argue that this is in line with the hypotheses that

the market overestimates acquirers management past performance. This results in overestimation of

acquirers’ management ability to manage other companies. This complements the research

conducted by Hayward & Hambrick (1995). They state that M&A premiums are positively correlated

with factors that measure past managerial performance. Apparently the market does not realize that

managerial performance in the past does not guarantee positive future performance.

Rau and Vermaelen (1998) also investigated whether there was a difference in post merger

performance between the takeover of public and private target firms. They reported significant

CAAR’s of -2.58% and -4.04% for respectively public target firms and the entire sample, suggesting

that the acquisition of a publicly traded target results in better performance with respect to privately

held target. Cosh & Guest (2001) investigated whether there was a difference in performance

between friendly and hostile mergers (using a 4 year post merger period and a benchmark return

corrected for size and book-to-market). They reported negative returns of -22.1% and -4.0% for

respectively friendly and hostile mergers suggesting that hostile mergers outperform friendly

mergers. The returns for friendly mergers are however not significant. These results are in line with

the research of Loughran and Vijh (1997) which I presented earlier.


20

The post merger performance for acquiring shareholders seems to be negative, although numerous

studies do not find significant results. However, the performance is apparently dependent upon the

method of payment and the acquisition type.

3.3. Conglomerate performance

The concept of diversification in the third takeover wave resulted in the creation of conglomerates.

Merger deals in the third wave were predominantly conglomerate deals, but these deals also happen

outside this period. A deal is specified as conglomerate when the target competes in an unrelated

industry. Leeth and Borg (2002) researched unrelated diversification prior to the third takeover. For

target shareholders they reported significant positive returns on the short term of 12.87% and

73.72% for respectively related mergers and unrelated mergers. Acquiring shareholders short term

returns are slightly positive for related mergers and around -2% for unrelated mergers but are not

significant.

Morck et al (1988) researched the effects of unrelated diversification on acquiring shareholders on

the short term, analyzing a period after the third merger wave. They report a significant negative

return of -4.09% for unrelated mergers and a significant positive return of 2.88% for related mergers.

Hubbard and Polia (1999) conducted a study which focused on the third merger wave. They

researched the short term performance of acquiring shareholders. Related mergers resulted in a

significant return of 1.61% and unrelated mergers resulted in a return of 0.24% (not significant).

The long term performance for acquiring shareholders and the relationship between unrelated

diversification is researched by Haugen and Udell (1972). They researched the third merger wave and

reported positive CAAR’s of 3% and 6.6% for respectively related and unrelated mergers. Only the

unrelated mergers returns are significant.

Again, target shareholders gain significant returns in related and unrelated mergers. The case for

acquiring shareholders is different. Before and after the third takeover wave short term returns for

related mergers are positive but negative for unrelated returns. During the third merger wave

however, unrelated diversification does seem to earn positive returns although not significant.

3.4. Summary

The statement whether mergers and acquisitions create or destroys value has to be treated with

care. There is a difference in performance between the target and bidding shareholders as shown by

previous research. This difference depends on a number of factors like relatedness of markets,

attitude towards the deals and the source of payment. The takeover decision always has to be taken

with care. Management should be aware that an M&A strategy by itself will probably not create any

significant value. A takeover, like any project, should return its opportunity costs or more.


21

Table 3.1 – Short term merger and acquisition performance for the combined shareholders

Study, sample country Sample period Benchmark

return model Sample size

Event window (days)

Type of merger CAARs combined

(%)

Franks et al (1991), US 1972-1987 MM 399 (0, close) all MA +3.90i

Servaes (1991), US 1972-1987 MM 577 (0, close) FA +3.29i

125 (0, close) HA +5.08iii

Mulherin and Boone (2000), US 1990-1999 MAM 376 (-1, +1) MA-public +3.56i

Graham et al (2002), US 1980-1995 MM 356 (-1, +1) all MA +3.40i

Table 3.2 – Short term merger and acquisition performance for the target shareholders



Event window (days)

Type of merger Target CAARs (%)

Eckbo (1983), US 1963-1978 MM 102 (-1, +1) HM +6.24i

Malatesta (1983), US 1969-1974 MM 256 (0, +20) M +16.80i

Servaes (1991), US 1972-1987 MM 577 (0, close) FA +21.89i

125 (0, close) HA +31.77i

Schwert (1996), US 1975-1991 MM 959 (-42, -1) M +11.90ii

TO +15.60ii

Andrade et al (2000), US 1973-1979 MM 598 (-1, +1) All deals +16.0ii

1980-1989

1226 (-1, +1)

+16.0ii

1990-1998

1864 (-1, +1)

+15.9ii


22

Table 3.3 – Short term merger and acquisition performance for the acquiring shareholders



Event window (days)

Type of merger Acquiring CAARs

(%)

Eckbo (1983), US 1963-1978 MM 102 (-1, +1) HM +0.07

Servaes (1991), US 1972-1987 MM 577 (0, close) FA -0.16

125 (0, close) HA -4.71

Schwert (1996), US 1975-1991 MM 959 (-42, -1) M +1.40

TO +1.70

Andrade et al (2000), US 1973-1979 MM 598 (-1, +1) All deals -0.3

1980-1989

1226 (-1, +1)

-0.4

1990-1998

1864 (-1, +1)

-1.0

Table 3.4 – Long term merger and acquisition performance for the acquiring shareholders



Event window (months)


(%)

Malatesta (1983), US 1969-1974 MM 256 (0, +36) M -7.60i

Agrawal et al (1992), US 1955-1987 Size + Beta adj. 222 (0, +60) TO +2.20

937 (0, +60) M -10.26i

Loughran and Vijh (1997), US 1970-1989 Size + B/M 100 (0, +60) TO-all +56.2ii

292 (0, +60) M-Stock -5.90

142 (0, +60) M-Cash +33.90ii

Rau and Vermaelen (1998), US 1980-1991 Size + B/M 643 (0, +36) M-Public -2.58i

2823 (0, +36) M-All -4.04i


23



Event window (months)


(%)

Cosh and Guest (2001), US 1985-1996 Size + B/M 58 (+1, +48) HA -4.0

123 (+1, +48) FA -22.10i

The following notations are used. Type of merger: M = Merger, TO = Tender Offer, HA = Hostile Acquisition, FA = Friendly Acquisition, HM = Horizontal

Merger, MA = Mergers and Acquisitions. Significance level: (i), (ii), (iii) significant at the 1%, 5% and 10% respectively.


24

RESEARCH ON LONG-TERM ACQUIRING’ SHAREHOLDERS RETURN

4. DATA

4.1. Sample selection

The examination in this paper will be on the post-merger performance of acquiring firms in the 21st

century in the US market. The sample period lies between January 2000 and December 2007 and will

only include domestic deals, meaning that the target and acquirer are both located in the US.

Because the analysis will be on the long term performance a three year window is chosen for the

data selection.

The SDC database is used to extract the data for the mergers and acquisitions in the sample period.

Only those deals that were completed in the sample period and have disclosed information

concerning the deal are included in the research. Furthermore, both the target and the acquirer are

public companies. In order to give a general conclusion about M&A performance and to give an

industry wide perspective the sample only includes deals with a transaction value larger than 500

million US dollars.

After the sample selection, I retrieved the monthly company data from the WRDS database. Besides

company specific data, I retrieved portfolio data and market data from the WRDS database.

4.2. Sample statistics

The above mentioned criteria led to a sample of 572 deals. See table 4.1 for an overview concerning

the deal attitude of the mergers. The research will focus on mergers that are friendly, i.e. the merger

has the approval of targets management, to prevent mixed results and because of the low

percentage of deals with an attitude that is other than friendly.

Table 4.1 – Deal Attitude

Deal Attitude Number of deals

Friendly 558

Hostile 8

Not Applicable 4

Neutral 1

Unsolicited, but not Hostile 1

Total 572

After cleaning up the data, excluding double and missing data, the dataset contains 492 friendly

mergers. The distribution of mergers in the period 2000 until 2007 is shown in table 4.2 and figure

4.1. From the table and graph you can see a significant drop in the number of mergers after 2000 and

a gradual increase after the mergers from 2002 onwards. The drop is most likely due to the burst of

the internet bubble and its following recession. Such a decrease in merger activity is expected after

or during a recession because of restricted organizational resources, but the numbers also show a


25

fairly quick recovery of merger activity. Perhaps the presence of low interest rates led to this quick

recovery, due to the fact that borrowing becomes cheaper which could spur investments, i.e. merger

activity.

Table 4.2 – Number of Deals Figure 4.1 – Number of Deals

Year Number of deals

2000 107

2001 63

2002 28

2003 39

2004 51

2005 66

2006 63

2007 75

Total 492

In the tables below various subsamples are presented which could be helpful for further analysis.

Table 4.3 divides the merger deals into conglomerate, horizontal and vertical deals and indicates that

the majority of the deals are horizontal, i.e. target and acquirer compete in the same industry. We

can use this distribution for analyzing the post-merger performance of acquiring firms to see whether

there exists a difference. Current consensus is that conglomerate mergers create negative

performance.

In table 4.4 the method of payment is shown. Table 4.5 and table 4.6 list the Macro-Industry

distribution of the acquirer and the target.

Table 4.3 – Merger Type Table 4.4 – Payment Method

Type of merger Number of deals

Method of payment Number of deals

Conglomerate 75

Payment in Stock 142

Horizontal 328

Payment in Cash 119

Vertical 90

Combined Cash + Stock payment 232

Total 492

Total 492

0

20

40

60

80

100

120


26

Table 4.5 – Acquirer Industry Table 4.6 – Target Industry

Acquiror Macro Industry Number of deals

Target Macro Industry Number of deals

Financials 94

Financials 76

High Technology 95

Energy and Power 53

Energy and Power 52

Media and Entertainment 30

Healthcare 80

High Technology 102

Telecommunications 22

Healthcare 75

Consumer Staples 17

Telecommunications 24

Media and Entertainment 29

Consumer Products and Services 23

Real Estate 24

Consumer Staples 20

Retail 15

Real Estate 23

Industrials 34

Industrials 39

Materials 17

Materials 17

Consumer Products and Services 13

Retail 10

Total 492

Total 492

5. METHODOLOGY

Fama, Fisher, Jensen, and Roll (1969) measure stock performance by correcting it with a benchmark

which is based on the firm’s beta. The beta describes the relation between the firm and the market

(for example the NASDAQ or NYSE). When this beta is positive the firm is assumed to follow the

trend of the market, a negative beta assumes the opposite. So in order to create a proper measure

for comparing performance we need a measure that will give a return above (or below) that of what

the market is (was) expecting.

Why should we reinvent the wheel when we can also use good, proper measures computed

previously. That is why in this paper the abnormal return is calculated using a measure that is based

on the methodology of Mandelker (1974) and Agrawal, Jaffe and Mandelker (1992). The measure

that will be used is based on the capital-asset-pricing model (CAPM), which describes the relationship

between the return of the firm and its risk.

5.1. Formulas

The abnormal stock performance, 𝜀𝑖𝑡, will be calculated as follows:

(1) 𝜀

Where Rit is the return of security i over month t. βi is the beta of security i, and the beta is calculated

using monthly data from +1 month to +36 months after merger announced. Rmt is the return on the

market index and Rft is the risk-free-rate in month t. Rpt is return of the control portfolio and Bp is the

beta of the control portfolio. The beta is the exposure of the security to the market and is calculated

as follows:


27

(2)

The average abnormal return (AAR) over all stocks in period t is:

(3)

∑ 𝜀

Where Nt is the number of securities in the sample with a return in event period t. The cumulative

average abnormal return (CAAR) from month t1 to t2 is:

(4)

∑

In order for the results to be accurate I included another formula for the abnormal return in my

analysis. This formula includes adjustment factors for value and growth firms and for momentum

trading as constructed by Kenneth R. French6. The second formula for the calculations of abnormal

returns is:

(5) 𝜀 ( )( ) ( ) (

)

The first part of the above formula (5) is the same as formula (1) and it corrects the realized returns

for size and for market exposure. The second part corrects the realized returns for value and growth

firms, where value firms have high book-to-market ratios and growth firms the opposite. The final

part corrects the realized returns for momentum trading.

5.2. AAR and CAAR calculations

So the abnormal returns in my analysis are calculated using factors that correct the realized returns.

First, a size factor in the form of a portfolio return is subtracted from the realized return. Dimson and

Marsh (1986) report evidence that the long-term returns have a significant size bias, meaning that

when the sample contains relative many large corporations the abnormal returns are inaccurate.

Agrawal, et al (1992) elaborate on this and state that excess returns are strongly related to firm size

since small firms are more responsive to some priced factor than large firms.

Since the sample in the analysis contains predominantly large corporations, because of the >500

million merger value criteria, the size correction is important. I used a portfolio based on market

capitalization constructed by Kenneth R. French where corporations are assigned to three different

classes; low (1), medium (2) and high (3) market capitalization. The low class represents the bottom

30% of all NYSE, AMEX and Nasdaq stocks, the high class represents the top 30% and the medium

class the remaining. Corporations of interest to our sample are assigned to a portfolio using the

WRDS database which distributes all NYSE, AMEX and Nasdaq stocks into a 1 to 10 scale based on

market capitalization (where 1 is low market capitalization and 10 is high market capitalization).

Since this analysis only includes mergers with a deal value above or equal to 500 million dollars the

majority of the corporations fall in class 37.

After subtracting the portfolio return from the realized return, the exposure to the market is

calculated using the beta of the corporation. Because the beta describes the relation between the

6 Go to http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ for more details.

7 90% of the sample falls in class 3, and 10% in class 2.

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/


28

security and the market, a beta of 0 for example assumes that the security moves indifferently from

the market. Thereafter the beta should be multiplied with the market risk premium (market return

minus risk free rate) to see what the expected return should be based on market exposure. Because

the realized return is already subtracted with the portfolio return the ‘excess’ beta, i.e. beta of the

corporation minus the beta of the portfolio, should be multiplied with the market risk premium.

The above part describes formula (1) and therefore the method of Agrawal, et al (1992). In formula

(5) the realized returns are also corrected for value versus growth corporations and momentum

trading as constructed by Kenneth R. French. The HML (high-minus-low) factor is the difference

between high and low book-to-market corporations, because previous research has shown that

‘value’ stocks (high book-to-market ratio) outperform ‘growth’ stocks (low book-to-market ratio).

Rau and Vermaelen (1998) find that there is an underperformance of ‘glamour’ acquisitions, i.e.

growth stocks. The momentum factor is an average of the return of high prior return portfolios

subtracted with the average of low prior return portfolios. This factor should correct for momentum

trading apparently inherent to capital markets. Both the momentum factor and the HML factor are

thereafter multiplied with the excess beta, i.e. difference between the beta with the relevant factor

and the beta of the portfolio with this factor. This is the case because the realized return has already

been subtracted with the portfolio return.

5.3. Test statistics

After calculations the abnormal returns need to be tested to see whether they are statistically

significant. The hypothesis to be tested to see whether the AAR is different from zero is:

(6) H0 : E (ARit)=0

The following formulas display the test statistics and standard deviations calculations for the AARs

and CAARs:

(7) 𝑡 𝑡 𝑡𝑖 𝑡𝑖 √

(8) √

∑

(9) 𝑡 𝑡 𝑡𝑖 𝑡𝑖 √

(10) √

∑


29

6. LONG-TERM ACQUIRING SHAREHOLDERS RETURN

6.1. Performance results of entire sample

After determining the sample and collecting the data I calculated the average returns, average

abnormal returns and the cumulative average abnormal returns and tested the latter two. Table 6.1

displays the average results for holding periods of one to three years after the merger

announcement. Apart from the average realized returns, the AARs and CAARs are also displayed and

tested.

The results indicate that there is a positive realized return of 0.57% for the entire sample for a one

year holding period, i.e. one year after merger announcement. Returns in the second year are

negative with an average of -2.48% whilst the third year returns are again positive and above the

10%. The three year holding period (cumulative three year returns) therefore is 9.92%.

6.1.1. AAR – CAAR – Size and Beta corrected

The results of the AARs and CAARs corrected for size and beta are shown in table 6.1 under (2). The

AAR for a one year holding period is 2.24%, although the test statistics indicates that it is not

statistically different from 0. However, the AARs in the second and third year are respectively 2.92%

and 4.69% and they are significant at respectively the 10 % and 1% level. The three year holding

period therefore becomes 9.85%, significant at the 1% level. The numbers seem to indicate that

there is a significant over-performance of mergers and acquisitions in the long-term, i.e. three years

after the merger. This finding is contradictory to previous research and I will therefore attempt to

identify the drivers behind this over-performance.

6.1.2. AAR – CAAR – Size, Beta, Book-to-Market and Momentum corrected

AARs and CAARs corrected for the book-to-market value and momentum, besides size and beta, are

also shown in table 6.1. These results seem even stronger than the previous one presented. The one,

two and three year AARs are respectively 5.85%, 4.49% and 4.03% and all statistically significant.

Only the average abnormal returns in the third year are lower in this model compared to the

previous one. The three year holding period return is 14.38%. One would expect that the abnormal

returns would be lower after additional correction factors, but the contrary holds.

6.1.3. AAR and CAAR distribution

The figure below displays the monthly distribution of AARs and CAARs of the entire sample using the

method of size and beta correction. The dotted lines in AAR distribution are the monthly abnormal

returns that are statistically different from zero. From the AAR distribution we can see that the

abnormal returns behave volatile, i.e. have large fluctuations. The distribution of CAARs suggests that

in the first year the cumulative abnormal returns increase gradually. On the other hand, the second

year shows ups and downs in abnormal returns. Finally the third year apparently is accompanied with

large increases in monthly cumulative abnormal returns.


30

Table 6.1 - Long term returns for acquiring shareholders

The table below displays the returns for acquiring shareholders, under (1) the returns and

cumulative returns are shown for mergers between 2000 and 2007. The (cumulative)

abnormal return for firm i in mongh t under (2) is calculated using the following formula:

(2)

The (cumulative) abnormal return for firm i in month t under (3) is calculated as follows:

(3)

The test statistics are shown under the AARs and CAARs.

Months after completion

(1) (2) (3)

Return C. Return AAR CAAR AAR CAAR

1-12 0,57% 0,57% 2,24% 2,24% 5,85% 5,85%

1,42 1,42 2,99a 2,99

a

13-24 -2,48% -1,92% 2,92% 5,16% 4,49% 10,35%

1,79c 2,40

b 2,64

a 3,57

a

25-35 11,84% 9,92% 4,69% 9,85% 4,03% 14,38%

2,57

a 3,82

a 2,19

b 3,72

a

a,b,c is significant at respectively the 1%, 5% and 10% level

Figure 6.1 – Distribution of AARs and CAARs (size and beta corrected)

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

1 4 7 10 13 16 19 22 25 28 31 34

Distribution of CAARs

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

1 4 7 10 13 16 19 22 25 28 31 34

Distribution of AARs


31

6.2. Yearly AAR performance

Table 6.2 displays the yearly AARs and CAARs for the size and beta corrected returns. Except for

2005, all the three year CAARs are positive. Notable are the returns of 2000 and 20007. Also

remarkable are the returns for mergers after, or during, an economic recession (see table below (*)).

These returns seem to indicate that M&A strategy is valued profitable after an economic recession.

Table 6.2 - Long Term Results for Acquiring Shareholders (yearly)

The table below displays the AARs and CAARs for mergers between 2000 and 2007.


AAR

2000 2001 2002 2003 2004 2005 2006 2007

1-12 3% 6% 9%* 4% 5% 0% -4% 0%

13-24 2% 10%* 3% 1% -5% -3% -4% 16%*

25-35 14%* -2% 1% 1% 3% -4% 16%* -1%


CAAR

2000 2001 2002 2003 2004 2005 2006 2007

1-12 3% 6% 9% 4% 5% 0% -4% 0%

13-24 5% 15% 13% 4% 0% -3% -8% 16%

25-35 20% 13% 13% 6% 2% -7% 9% 15%

*merger returns during/after an economic recession.

6.3. Horizontal, Vertical and Conglomerate performance

The focus of a corporation has been an important factor in the merger waves throughout history.

Whether it is the creation of monopolies, industry integration or diversification all were of influence

on the occurrence of the waves and their performance also differs. This section will analyze the

performance of horizontal, vertical and conglomerate mergers. As described in section 4, the

majority of the sample constitutes of horizontal mergers, with 328 observations. Conglomerate and

vertical mergers on the other hand have respectively 75 and 90 observations. Table 6.3 and 6.4

display the results of corporate focus of respectively size and beta corrected AARs and size, beta,

book-to-market and momentum corrected AARs.

The average abnormal returns in table 6.3 are all positive with the exception of the one year holding

period return for vertical mergers (-2.41%). The three year holding period returns for horizontal,

vertical and conglomerate mergers are respectively 9.95%, 5.37% and 14.77%. The vertical mergers

return however does not seem to be significantly different from zero. Horizontal mergers are

statistically the most significant. Research conducted by Peer (1980) in the Netherlands between

1962 and 1973 also reported a positive 3 year abnormal return of 2.26%. However, the research

reported a negative return of -1.84 for unrelated mergers.


32

Table 6.3 - Horizontal, Vertical and Conglomerate merger performance (1)

The table below displays the AARs and CAARs for mergers from 2000 until 2007, divided between horizontal, vertical

and conglomerate mergers. The abnormal returns are calculated using the following formula:

Months after

completion

AAR CAAR

Horizontal Vertical Conglomerate Horizontal Vertical Conglomerate

1-12 3,31% -2,41% 3,11% 3,31% -2,41% 3,11%

1,99

b -0,48 0,71 1,99

b -0,48 0,71

13-24 1,47% 3,14% 9,00% 4,78% 0,72% 12,11%

0,76 0,83 1,85

c 1,94

c 0,12 2,14

b

25-35 5,17% 4,64% 2,66% 9,95% 5,37% 14,77%

2,26

b 1,02 0,68 3,22

a 0,78 2,38

b


Table 6.4 - Horizontal, Vertical and Conglomerate merger performance (2)

The table below displays the AARs and CAARs for mergers from 2000 until 2007, divided between horizontal, vertical

and conglomerate mergers. The abnormal returns are calculated using the following formula:

Months after

completion

AAR CAAR


1-12 2,98% 15,32% 7,21% 2,98% 15,32% 7,21%

1,30 2,75

a 1,60 1,30 2,75

a 1,60

13-24 2,22% 11,12% 6,59% 5,19% 26,44% 13,80%

1,11 2,37

a 1,57 1,57 3,10

a 2,05

b

25-35 2,55% 10,24% 3,14% 7,74% 36,68% 16,94%

1,17 2,12

a 0,65 1,78

c 3,12

a 1,90

c


Table 6.3 displays the results for abnormal returns corrected for size, beta, book-to-market and

momentum factors. The results for horizontal and conglomerate mergers are somewhat the same as

for the previous model, although the results are less significant. The striking difference lies with the


33

vertical mergers. In the previous model vertical mergers showed small negative and positive

insignificant returns. When also corrected for book-to-market and momentum the vertical mergers

suddenly perform exceptionally well with returns of over the 10% in every year and showing strong

statistical significance. The difference between the two abnormal returns still has to be determined.

6.4. Method of Payment

Previous research on the difference between stock paid mergers versus cash paid mergers is

extensive. Stock paid mergers usually represent a signal that the acquirers stocks are overpriced and

will therefore on average lead to negative performance on the short term. The long term

performance of cash and stock paid mergers is investigated by Loughran and Vijh (1997) and they

reported a five year merger performance of 33.90% for cash paid mergers and a -5.90% return for

stock paid merger.

As mentioned in section, my analyses consists of 142 stock paid mergers, 119 cash paid mergers and

232 mergers paid for in a combination of stock and cash. Table 6.4 displays the results for the

abnormal returns corrected for size and beta. All abnormal returns are positive although most lack

statistical significance. The three year holding period returns for cash, stock and combined payment

are respectively 7.74%, 8.64% and 11.68% and all are statistically significant. Notable are the returns

for stock paid mergers which are slightly positive (not significant) in the first two years but then

shows a significantly return of over 8% in the third year. Cash and combined paid mergers show more

equally distributed returns throughout the three year period.

The results for the abnormal returns corrected for size, beta, book-to-market and momentum are

presented in table 6.5. These results are again different from the previous model. Similar is that most

returns are not statistically significant but the main difference lies with stock paid mergers. In this

model the stock paid mergers earn a significant abnormal return of over 20% in the first year and

over 10% in the following two years (all statistically significant). Mergers paid for in cash show small

positive insignificant returns and mergers paid for in cash and stock earn negative returns in all years,

although not significant. Again, both models display quite opposite results which is remarkable.


34

Table 6.5 – Method of Payment (1)

The table below displays the AARs and CAARs for mergers from 2000 until 2007, divided between mergers paid for

in cash, stock and a combination of both. The abnormal returns are calculated using the following formula:

Months after completion AAR CAAR

Cash Stock Combined Cash Stock Combined

1-12 1,93% 0,28% 3,60% 1,93% 0,28% 3,60%

0,72 0,08 1,66

c 0,72 0,09 1,66

c

13-24 1,67% 0,09% 5,28% 3,60% 0,37% 8,88%

0,62 0,03 2,21

a 0,94 0,09 2,89

a

25-35 4,14% 8,27% 2,80% 7,74% 8,64% 11,68%

1,56 2,23

a 0,96 1,95

c 1,66

c 3,02

a


Table 6.6 – Method of Payment (2)



Months after completion AAR CAAR


1-12 1,30% 22,95% -2,20% 1,30% 22,95% -2,20%

0,44 4,58

a -1,02 0,44 4,58

a -1,02

13-24 0,89% 11,45% 2,11% 2,19% 34,40% -0,09%

0,35 2,82

a 0,93 0,54 4,59

a -0,03

25-35 1,85% 14,30% -1,09% 4,03% 48,70% -1,17%

0,65 3,57

a -0,41 0,86 4,77

a -0,27



35

6.5. Industry Performance

According to Sudi Sudarsanam (2003) M&A activity seems to be correlated with industry-specific

factors. Therefore this section analyzes the long-term performance of mergers and acquisitions on an

industry level. Tables 6.6 and 6.7 presents the industry level abnormal returns for respectively size

and beta corrected abnormal returns and size, beta, book-to-market and momentum corrected

abnormal returns. Industries with the most observations in my sample are the Financials, Healthcare

and High Technology industries8. For a complete distribution of the sample with respect to the

industries see section 5.

Size and beta corrected abnormal returns for our dominant industries, being High Technology,

Financials and Healthcare, are respectively 27.22%, -7.03% and 4.68% for a holding period of three

years. Only the returns for the High Technology are statistically significant. Other industries that have

significant large outcomes are the Energy and Power, Industrials and Real Estate industries all having

three year holding returns between 20 and 30%. The industry of Telecommunication shows

significant negative abnormal return of -30.85% for a three year holding period.

Again, the other model seems to differ significantly. For instance, the High Technology industry earns

significant positive abnormal returns over 30% each year compared to a three year holding period

return of 27.22% in the previous model. The High Technology returns in the second model therefore

seem unlikely. An anomaly like this could be, as stated by Fama (1991), due to incorrect risk

adjustments but I will elaborate more on this in the following section. The three year holding return

for the industry Healthcare is about the same and again not significant. The Financials industry on the

other hand, has a three year holding return of -20.12% in the second model, this time it is statistically

significant. The models produce different results again and will be discussed in the following section.

8 Financials: 94 observations, Healthcare: 80 observations and High Technology: 96 observations.


36

Table 6.7 - Industry Long term returns for Acquiring Shareholders (1)

The table below displays the industry specific AARs and CAARs for mergers between 2000 and 2007. The abnormal returns using the following formula:


Consumer Products and Services

Consumer Staples Energy and Power Financials Healthcare High Technology

AAR CAAR AAR CAAR AAR CAAR AAR CAAR AAR CAAR AAR CAAR

1-12 15,46% 15,46% 11,25% 11,25% 9,46% 9,46% 0,13% 0,13% 1,40% 1,40% -5,60% -5,60%

1,62 1,62 1,60 1,60 2,67

a 2,67

a 0,06 0,06 0,42 0,42 -0,99 -0,99

13-24 -12,01% 3,45% 6,86% 18,11% 4,79% 14,25% -3,40% -3,28% -1,70% -0,30% 7,70% 2,10%

-1,53 0,30 0,99 2,13

b 0,99 3,07

a -0,87 -0,87 -0,49 -0,08 1,41 0,25

25-35 11,51% 14,96% 0,90% 19,02% 6,20% 20,45% -3,75% -7,03% 4,98% 4,68% 25,12% 27,22%

1,19 1,05 0,18 3,04

a 1,36 3,36

a -0,99 -1,61 1,32 1,03 2,71

a 3,36

a


Industrials Materials Media and

Entertainmnet Real Estate Retail Telecommunications


1-12 14,98% 14,98% 7,75% 7,75% -3,55% -3,55% 8,93% 8,93% -3,88% -3,88% -11,26% -11,26%

3,57

a 3,57

a 1,00 1,00 -0,55 -0,55 1,10 1,10 -0,46 -0,46 -1,48 -1,48

13-24 13,45% 28,43% 4,81% 12,55% -6,65% -10,21% 22,80% 31,72% 6,16% 2,28% -13,48% -24,74%

2,72

a 4,17

a 0,85 1,67

c -0,76 -1,78

c 4,43

a 3,85

a 0,55 0,20 -1,72

c -2,17

b

25-35 1,11% 29,54% 2,84% 15,40% 5,59% -4,61% -2,35% 29,37% 0,25% 2,53% -5,61% -30,35%

0,19 3,73

a 0,51 1,54 0,43 -0,26 -0,62 3,07

a 0,03 0,18 -0,81 -2,62

a


37

Table 6.8 - Industry Long term returns for Acquiring Shareholders (2)

The table below displays the industry specific AARs and CAARs for mergers between 2000 and 2007. The abnormal returns using the following formula:


Consumer Products and Services

Consumer Staples Energy and Power Financials Healthcare High Technology


1-12 11,97% 11,97% -17,08% -17,08% -1,76% -1,76% -8,86% -8,86% -0,06% -0,06% 38,01% 38,01%

1,23 1,23 -2,04

b -2,04

b -0,47 -0,47 -3,24

a -3,24

a -0,02 -0,02 5,76

a 5,76

a

13-24 -12,91% -0,94% -4,58% -21,65% -3,84% -5,60% -4,61% -13,47% -1,58% -1,64% 24,10% 62,11%

-1,78 -0,08 -0,62 -1,70

c -0,88 -0,97 -1,35 -3,16

a -0,43 -0,33 4,37

a 6,34

a

25-35 9,54% 8,60% -9,54% -31,19% -1,98% -7,58% -6,65% -20,12% 5,39% 3,74% 35,37% 97,48%

1,02 0,52 -1,87

c -2,21

b -0,40 -1,15 -1,71

c -4,18

a 1,54

0,60 3,77

a 7,30

a


Industrials Materials Media and

Entertainmnet Real Estate Retail Telecommunications


1-12 4,50% 4,50% -6,86% -6,86% -0,05% -0,05% 13,35% 13,35% -2,47% -2,47% -1,77% -1,77%

0,95 0,95 -0,75 -0,75 -0,01 -0,01 1,85

c 1,85

c -0,37 -0,37 -0,22 -0,22

13-24 7,19% 11,69% -0,96% -7,81% 3,77% 3,72% 19,63% 32,97% 9,85% 7,38% -12,76% -14,53%

1,28 1,54 -0,18 -0,79 0,39 0,49 3,31

a 3,09

a 0,98 0,65 -1,55

c -1,53

25-35 -0,26% 11,44% -8,75% -16,56% 3,96% 7,68% -10,25% 22,72% -1,53% 5,86% -2,78% -17,31%

-0,06 1,25 -1,45 -1,46 0,40 0,41 -1,96

b 1,71

c -0,26 0,44 -0,38 -1,32



38

7. INTERPRETATION OF THE RESULTS

This section will analyze the outcomes of the research and will provide some general conclusions that

can be drawn from the research. The overall results suggest that the long term performance of

acquiring shareholders is positive which is contradictory to previous research. Other studies reported

significant underperformance for acquiring shareholders in the long term; therefore the results in my

analysis are ambiguous to say the least and should be handled with caution. Furthermore, Fama

(1991) stated that anomalies in stock market returns occur due to incorrect risk adjustment and risk

estimation procedures.

So, is the long term over-performance of acquiring shareholders an anomaly caused by incorrect risk

adjustments, i.e. benchmark returns, or are the capital markets in the sample period to pessimistic

about synergies and profitability of mergers and acquisitions? Pessimistic in the sense that investors

do not properly incorporate M&A related factors on profitability into share prices. Since share prices

should reflect the present value of all expected future cash flows, a finding of over-performance in

the long term for acquiring shareholders therefore suggests that share prices are on average

undervalued around announcement for corporations undertaking M&A investments. Previous

research on the other hand reported the opposite; over optimistic investors about future profitability

of M&A’s leading to significant negative performance in the long term when expectations did not

matched reality.

The model I used for calculating the abnormal returns corrects the realized returns with a size and

beta measure. This model is deducted from the model used by Agrawal et al (1992) and is based on

the same assumptions. In their research they reported a significant level of underperformance for

acquiring shareholders in the long run (5 year period). The research reported significant negative

returns in the 50s, 60s and 80s. However the returns in the 70s were positive, although not

significant. Besides a period analysis the research also conducted an analysis concerning corporate

focus. In their sample conglomerate mergers generate a 5 year abnormal return of -8.6%, whilst non-

conglomerate mergers generate a on average a 5 year abnormal return of -25.5%. Apparently,

conglomerate mergers seem to perform better in their sample but other studies indicate the

opposite and state that diversification is more value destroying.

The finding of underperformance for acquiring firms in the long run suggests according to Agrawal et

al (1992) that the capital markets are not efficient. Since efficient capital markets should reflect all

relevant information into the share prices around the merger announcement. Furthermore, they

state that caution is advised since there are some methodology problems and conflicting results

between studies. The methodology is based upon assumptions and it tries to isolate the merger

effect in the long run which increases the probability of a biased outcome.

Results reported in the previous section indicate that there is a significant over-performance for

acquiring shareholders in the long run. The three year cumulative average abnormal returns is 9.85%

and statistically different from zero. Now that I have established a statistically significant return I will

try to connect it with economic significance. Since there is almost no literature on long term over-

performance for acquiring shareholders it is difficult to assess if these results are economically viable.

A level of over-performance in the long run assumes, as is the case with underperformance, that the

share prices around merger announcement do not accurately reflect all future cash flow of the


39

corporation including those generated by the merger. Previous research suggests that share prices

were overvalued around merger announcement resulting in significant negative performance in the

long run when expectations were not matched with reality. A finding of over-performance on the

other hand suggests that share prices are undervalued around merger announcement.

From the investors’ point of view under or over-valuation in Behavioral Finance is usually explained

by inefficient market arbitrage. The managerial perspective usually refers to behavioral biases and

general reference points as factors influences the pricing of capital assets. A finding of overvaluation

of stocks could lead to the market timing of mergers and acquisitions, as stated by Baker, Ruback and

Wurgler (2004). As mentioned before, market timing could be an important factor for the occurrence

of merger waves. However, my analysis suggests that acquiring shareholders assets are underpriced

since they earn a significant abnormal long term return. So the market timing concepts would

suggest that the presence of underpriced shares would lower M&A activity. Perhaps there is a

simultaneous presence of under and over-valued shares resulting from an overstressed market

leading to the acquisition of undervalued corporations by overvalued corporations, but this is

speculative and should be investigated further. However, if this is the case then the market timing

concept does hold which according to Myers and Majluf (1984) results in takeover activity by

managers due to overvaluation of equity.

But this still does not explain why there is abnormal performance in the long term for acquiring

shareholders. As expected, managers usually have more information about their own company and

about synergies of possible takeover opportunities. But any negative consequences of asymmetric

information for shareholders should be minimized with proper incentives. If the incentives in place

are not sufficient managers can pursue goals that are not always in the best interest for (short-term)

investors. On the other hand, managers may have different believes about possible synergies and

about the appropriate strategies with respect to investors. Perhaps a manager believes that it

increase its performance significantly by investing in takeover opportunities. Furthermore, the

managers will be focused more on the long term as oppose to investors whose time horizon is

usually much shorter and will therefore put more importance on the signaling effect of M&A’s, which

assumes the presence of overpriced shares with respect to merger announcements.

Is this a new trend that has emerged, where capital markets seem to be cautious in their assessment

of value created through mergers? Or is this an anomaly created by incorrect benchmarks and

incorrect adjustment factors, as advocated by Fama (1991)? To provide a more in-depth conclusion,

several subsamples are research to see whether this generates an explanation for the finding of over-

performance.

7.1. Subsamples

The subsamples that I analyzed are presented in section 6 and include analyses of corporate focus,

method of payment and industry level. Corporate focus describes strategic decision making of

corporations and is divided into horizontal, vertical and conglomerate mergers. As mentioned before,

horizontal mergers are takeovers within the same industry and vertical mergers are takeovers within

the same supply chain. Conglomerate mergers on the other hand are takeovers between unrelated

businesses. The first three merger waves were respectively dominated by horizontal, vertical and

conglomerate mergers.


40

In my analyses the horizontal, vertical and conglomerate mergers generate a three year abnormal

return of respectively 9.95%, 5.37% and 14.77%9. However, the abnormal returns for vertical

mergers are not statistically significant from zero. Apparently, industry consolidation seems to

perform better than vertical integration. Furthermore, conglomerate mergers appear to outperform

the two other strategies which is remarkable since many other studies claim the opposite. Jensen

(1986), for example, stated that conglomerate mergers probably perform worse, since managers of

acquiring firms are not familiar with the industry of the target or availability of free cash flow leads to

inefficient ‘empire’ building. Although many studies indicate that conglomerate mergers perform

worse than other mergers, Agrawal et al (1992) also indicated that conglomerate mergers perform

better than non-conglomerate mergers. However, the corporate focus of a corporation does not

explain the over performance of acquiring firms in the long run because all strategies earn a positive

abnormal return.

The method of payment divides my sample into mergers paid for in cash, stock and a combination of

both10. The abnormal returns, as presented in section 6, for cash, stock and combined paid mergers

are respectively 7.74%, 8.64% and 11.68%. All returns are statistically significant and all returns have

the same sign (i.e. are all positive) and do not differ significantly from each other. Therefore it is

difficult to connect the over performance of acquiring firms to the method of payment. It is however

notable that previous research reported that cash paid mergers on average perform better. Loughran

and Vijh (1997), for example, reported 5 year abnormal returns of -5.90 and 33.90% for respectively

stock and cash paid mergers. Loughran and Vijh (1997) explain this with the signaling effect and

market timing. They state that the payment in stock assumes overvaluation and apparently the

market does not efficiently react to the potential wealth gains of the business combination with

respect to the form of payment. Since there is no large difference between the abnormal returns of

stock and cash paid mergers it is ambiguous to say that the form of payments determines the long

term performance for acquiring shareholders.

Finally, I analyzed the long term abnormal performance on an industry level. As mentioned before

the dominant industries in my sample (based on the number of observations) are the Financials,

Healthcare and High Technologies industries. Remarkable are the results for the High Technology

industry showing a statistically significant abnormal return of 27.22% for a holding period of three

years. The High Technology industry seems to have a major impact on the overall performance and

will therefore be discussed in more depth.

7.2. High Technology Industry

The high abnormal return for the High Technology industry, as presented in section 6, needs to be

researched more thoroughly because the industry has many observations in my sample and

therefore has a major influence on the overall abnormal returns. In table 7.1 and 7.2 the distribution

of the High Technologies industry is shown with respect to the merger type and the payment

method.

9 Conglomerate mergers: 75 observations, Horizontal mergers: 328, Vertical mergers: 90 observations.

10 Cash paid mergers: 142 observations, Stock paid mergers: 119 observations, Stock and cash payment: 232

observations.


41

Table 7.1 – Merger Type Table 7.2 – Payment Method

Type of merger Number of deals

Method of payment Number of deals

Conglomerate 13

Payment in Stock 29

Horizontal 53

Payment in Cash 49

Vertical 29

Combined Cash + Stock payment 17

Total 95

Total 95

Sudi Sudarsanam (2003) stated that merger activity is most likely related with industry-specific

factors. Although my sample is dictated by three industries, the High Technology Industry seems to

be most influential on the overall performance because of its high abnormal returns and the

significance of the returns. Recall that the abnormal returns for the Financials and Healthcare

industries did not generate significant abnormal returns. Tables 7.3 and 7.4 display the abnormal

returns for the High Technology industry. Table 7.3 presents the results with respect to corporate

focus and table 7.4 with respect to method of payment.

Table 7.3 - Horizontal, Vertical and Conglomerate merger performance



Months after

completion

AAR CAAR


1-12 2,56% -19,35% 5,78% 2,56% -19,35% 5,78%

0,46 -1,46 0,51 0,46 -1,46 0,51

13-24 5,14% 9,70% 33,77% 7,70% -9,65% 39,54%

0,92 1,09 1,98

a 0,95 -0,64 2,51

a

25-35 21,27% 13,98% 13,16% 28,97% 4,33% 52,70%

2,61

a 1,33 0,84 2,94

a 0,26 4,10

a



42

Table 7.4 - Method of Payment - High Technology



Months after

completion

AAR CAAR


1-12 10,34% -7,21% 16,37% 10,34% -7,21% 16,37%

1,86

c -0,87 1,42 1,86

c -0,87 1,42

13-24 11,74% 5,51% 2,77% 22,08% -1,70% 19,13%

2,46

a 0,75 0,31 2,91

a -0,16 1,43

25-35 -0,82% 28,66% 16,47% 21,26% 26,95% 35,60%

-0,19 3,72

a 1,45 2,95

a 2,17

a 2,58

a


Both the results for corporate focus and method of payment have similar results than the overall but

the magnitude of the abnormal returns is considerably higher. This could confirm my belief that the

High Technology industry has a major impact on the abnormal returns of the entire sample. Similar

to the entire sample, horizontal consolidation generates higher abnormal returns than vertical

integration and diversification outperforms both. The three year abnormal returns for horizontal,

vertical and conglomerate mergers are respectively 28.97%, 4.33% and 53.70%. Again, the abnormal

returns for vertical mergers are not statistically different from zero.

The method of payment also presents similar results compared to the entire sample. Magnitude of

the abnormal returns for the High Technology industry is again considerably higher. Payment in

stock, cash and a combination of both generates a three year abnormal return of respectively

21.26%, 26.95% and 36.60%, all statistically significant.

Now questions arise concerning the significant abnormal performance of corporations competing in

the High Technology industry. A study conducted by Kohers and Kohers (2001) investigated the long

term performance of acquisitions involving high tech companies between 1984 and 1995. Their

research focused on the long term performance of acquiring shareholders that merged or taken over

a high tech company. Since it only involves high tech acquisitions, the study of Kohers and Kohers

(2001) only relates to the horizontal mergers in the High Technology industry in my analysis. The

study reported that on average high tech acquisitions result in significant underperformance and

suggests that the market tends to be over-enthusiastic about expected future benefits or synergies

from the acquisition of a high tech corporation. According to Kohers and Kohers (2001), high tech

acquisitions could not meet the high expectations about future benefits despite a positive initial

market reaction.


43

The results of my study tell a different story. As mentioned before, the horizontal mergers in the High

Technology industry earn a significant three year abnormal return of 28.97%. Perhaps this suggests

the opposite of the previously discussed study of Kohers and Kohers (2001). Because high tech

acquisitions in the 80s and 90s did not met the initial positive expectations, new high tech

acquisitions in the 21st century were handled with caution by capital markets. The over-optimism of

investors shifted to a more pessimistic perspective on potential future benefits and synergies of high

tech acquisitions. To see whether there truly is a change in perspective on the created synergies from

high tech acquisition, the study needs to be extended with an analysis of the abnormal performance

around the announcement of the acquisition. Furthermore, to give a more general conclusion about

the performance of high tech acquisitions, corporations that acquired a high tech company but is

outside the High Technology industry should be included.

Pessimistic investors could be an underlying for the over-performance of horizontal mergers in the

High Technology industry but this does not explain the three year abnormal return of 52.70% for

conglomerate mergers in the High Technology industry. To find an underlying for the measure of

over-performance I compared the NYSE composite with High Technology corporations (see graph

7.1). The graph shows a significant drop of the High Technology industry after the burst of the

internet bubble. It is not surprising that the drop is more significant than the drop of the market as a

whole since it were for a large part those corporations that created the bubble in the first place. The

burst of the internet bubble significantly devaluated the high tech corporations and this might

created potential opportunities due to undervaluation. Because the High Technology industry was

struck this hard, a changed strategy could be the underlying of better performance. Investments of

high tech corporations in unrelated industries, i.e. conglomerate mergers, could decrease the risk

involved and could perhaps make better use of its potential. Furthermore, industry consolidation

seems to be a viable strategy since corporations in the High Technology industry could have been

undervalued.

Graph 7.1 – NYSE composite and High Technology Index

0

200

400

600

800

1000

1200

1400

1600

0

2000

4000

6000

8000

10000

12000

1/1

/19

92

1/1

1/1

99

2

1/9

/19

93

1/7

/19

94

1/5

/19

95

1/3

/19

96

1/1

/19

97

1/1

1/1

99

7

1/9

/19

98

1/7

/19

99

1/5

/20

00

1/3

/20

01

1/1

/20

02

1/1

1/2

00

2

1/9

/20

03

1/7

/20

04

1/5

/20

05

1/3

/20

06

1/1

/20

07

1/1

1/2

00

7

1/9

/20

08

1/7

/20

09

1/5

/20

10

1/3

/20

11

NYSE High Technology


44

8. Conclusion

The results of this research indicate that there is an over performance in the long run for acquiring

shareholders which is contradictory to previous results who present the opposite. Apparently, M&A

activity in the 21st century has a positive long term effect for acquiring shareholders. Where, in the

past, announcement returns were overvalued resulting in negative long term returns when

expectations were not met. This research however, indicates that share prices are undervalued

around announcement, creating significant positive long term returns.

So, is the long term over-performance of acquiring shareholders an anomaly caused by incorrect risk

adjustments, i.e. benchmark returns, or are the capital markets in the sample period too pessimistic

about synergies and profitability of mergers and acquisitions?

More research needs to be done with respect to long term M&A performance in the 21st century, to

confirm the consensus in this paper that acquiring shareholders earn a significant positive return in

the long run, and therefore justifying M&A strategies followed by corporations. In section 6, I also

presented that the performance of acquiring shareholders was especially high after, or during, an

economic recession indicating that merger focused corporations are a “refuge” on the capital market

during economic difficult times. Especially conglomerate mergers seem to earn the highest returns,

which could indicate that during economic stagnation, investors have more confidence in

conglomerates, which are in general less risky since they have less exposure to industry specific risks.

The recent recession and perhaps a new upcoming recession shows that there is a lot of volatility in

the financial markets. In the “Subprime” recession, investment portfolios where not properly

adjusted for risk which meant a significant devaluation of these portfolios when mortgages in the

United States where defaulting on their payments. This led to significant devaluations of the

underlying portfolios which were created via securitization of the mortgage loans.

The current volatile climate is due to the large debt obligations of countries and the increased

probably that some might default on their obligations. A number of reasons can be at the heart of

this problem, for instance the interest rates on government bonds for countries like Greece and

Portugal where likely to be to low resulting in a climate where these countries borrowed to much at

too low costs with respect to the inherent risks. Capital markets did not account for these risks

sufficient enough leading to an extremely volatile market.

Although, research on this topic is extensive, a one-sided answer to the value of merger activity is not

available yet. This is also due to the fact that the performance of a merger deal is case sensitive,

meaning that the future profitability is dependent on individual characteristics like, management

expertise, available cash flow and also on market conditions. So, to conclude this research, all

investments, whether it is a projects investment or a merger, they all should return their opportunity

costs or more.


45

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