Long-run Post Merger Stock Performance of UK Acquiring Firms: A Stochastic Dominance Perspective

Abhay Abhyankar
School of Management and Economics, University of Edinburgh, Edinburgh EH8 9JY, UK

Keng-Yu Ho
Department of Finance, National Central University, Taoyuan 320, Taiwan

Huainan Zhao

Faculty of Finance, Cass Business School, London EC1Y 8TZ, UK

September 2006

Abstract We study, using the idea of stochastic dominance, the long-run post merger stock performance of UK acquiring firms. We compare performance by using the entire distribution of returns rather than only the mean as in traditional event studies. Our main results are as follows: First, we find that, in general, acquiring firms do not significantly underperform in three years after merger since we observe no evidence of first- or second-order stochastic dominance relation between acquirer and benchmark portfolios. Second, we find that acquirers paying excessively large premiums are

stochastically dominated by their benchmark portfolio implying that overpayment is a possible reason for post merger underperformance. We find, in consistent with previous studies, cash financed mergers outperform stock financed ones. Finally, we do not observe any evidence that glamour acquirers underperform value ones as no stochastic dominance relations between the two. In general, our results underline the importance of examining long-run post merger stock performance from alternative perspectives.

JEL Classification: D81, G11, G14, G34. Keywords: Stochastic Dominance, Mergers and Acquisitions, Corporate Takeovers, Abnormal Returns, Market Efficiency.

Corresponding author: Tel: +44-(0)20-7040-5253; fax: +44-(0)20-7040-8881.

Email address: h.zhao@city.ac.uk

1. Introduction

A general conclusion, based on studies of long-run (up to five years) stock performance following mergers, is that there is evidence of significant underperformance 1 . This finding, in contrast to the prediction of the efficient market hypothesis, is both interesting and puzzling because it presents an efficient market anomaly in general and a puzzle for merger activity in particular. Fundamentally, the question is whether mergers, on average, destroy firms value in the long run, or whether these findings are merely a result of flaws of methodologies used. This question is important to the formation of merger policies as well as to shareholders and managers.

The evaluation of post-merger stock price performance has relied almost exclusively on the metric of long-run abnormal returns using an event study approach. However this methodology is fraught with many econometric difficulties including the choice of a benchmark, the method used to compute abnormal returns, value- versus equalweighting of event firm portfolios, cross-sectional correlations in event time, nonnormality of the abnormal returns, and the choice of model for risk corrections (see, for example, Lyon, Barber, and Tsai, 1999 and Mitchell and Stafford, 2000). Moreover, some recent research (see for example, Schultz, 2004, Dahlquist and De Jong, 2003, and Viswanathan and Wei, 2004) questions whether the issue of long-run underperformance could be resolved using an event study framework. For example, Viswanathan and Wei

A non-exhaustive list of US studies includes for example: Asquith (1983), Malatesta (1983), Jensen and Ruback (1983), Magenheim and Mueller (1988), Agrawal, Jaffe, and Mandelker (1992), Loderer and Martin (1992), Anderson and Mandelker (1993), Loughran and Vijh (1997), Rau and Vermaelen (1998), and Agrawal and Jaffe (2000). Examples using UK data are: Firth (1979), Franks and Harris (1989), Limmick (1991), Limmack and McGregor (1995), Kennedy and Limmick (1996), Gregory (1997), Chatterjee (2000), Aw and Chatterjee (2004).

(2004) show that expected long-run abnormal returns using an event study methodology are negative in any fixed sample. Furthermore, they show that the statistical tests used in long-horizon event studies have low power when endogenous variation in the number of events is correctly accounted for. Given these findings it is of great interest to study long-run abnormal performance using an alternate methodology for comparing acquiring firm returns to commonly used benchmark portfolio returns.

Our main purpose in this paper is to explore, using the idea of stochastic dominance,2 whether investors with specific preferences would choose to invest in a merger portfolio of acquiring firms relative to a size and book-to-market matched benchmark portfolios commonly used in the literature. We therefore compare whether the cumulative distribution of the returns (or payoffs) to a merger portfolio stochastically dominate that of a benchmark portfolio. There are several advantages to using the idea of stochastic dominance for this exercise. First, we can compare the entire return distributions of the event and benchmark portfolios instead of just the mean portfolio return in order to mitigate the non-normality problem of long-horizon abnormal returns. More importantly, we do not need to specify an asset pricing model to estimate expected returns. Finally, we can allow for simple assumptions about investor preferences in the comparison of acquiring firm portfolios versus benchmark portfolios; for example, nonsatiation in the case of first-order stochastic dominance (FOSD) and risk aversion in the

Most standard finance textbooks (e.g., Huang and Litzenberger, 1988) include sections on the concept of stochastic dominance. However, we see few empirical applications in recent finance literature. Some early exceptions include Porter and Gaumnitz (1972), Porter (1973), Joy and Porter (1974), Tehrenian (1980), and more recently Post (2001) among others. We note that the methodology in Post (2001) focuses on portfolio diversification issues by comparing a given portfolio to a set of assets. In our paper, we only compare two return distributions and therefore do not use the linear programming method in Post (2001). Comparisons of income, wealth and earning distributions using tests for stochastic dominance are however common in empirical economics (see for example Anderson, 1996 and Davidson and Duclos, 2000).

case of second-order stochastic dominance (SOSD). This is important since the view of investors towards various benchmarks depends crucially on their risk preferences and investment goals.

Our main results are as follows. First, we find no evidence of any first- or second-order stochastic dominance relation between the merger portfolios and the benchmark portfolios matched on both size and book-to-market ratios. This result is consistent with the efficient market hypothesis and gives no support for the anomaly of long-run post merger underperformance. Second, we show that the benchmark portfolio stochastically dominates the merger portfolio that paid the highest merger premiums to the targets. This finding suggests that overpayment is a possible reason for the long-run underperformance of some acquiring firms. Third, we find that the cash-financed merger portfolio clearly dominates the benchmark portfolio while there is no evidence of stochastic dominance between stock-financed merger portfolio and the benchmark. This finding is consistent with previous evidence that cash-financed mergers outperform the stock-financed ones. Finally, in contrast to some recently evidence, we do not find the stylized value/glamour effect in mergers since we do not observe stochastic dominance relations between the value/glamour portfolio and the benchmark portfolio. The rest of the paper is organized as follows. In Section 2 we briefly review prior research on long-run post merger performance that relies exclusively on the event study methodology. In Section 3, we describe our data before outlining the methodology used in our tests for stochastic dominance. In Section 4 we present the empirical results and Section 5 concludes the paper.

2. Review of Previous Studies

We provide here a brief and selective review of prior research on long-run post merger underperformance3. A more comprehensive review is available in Agrawal and Jaffe (2000).

We begin with studies that use US market data. For example, Langetieg (1978) reports significant CARs (cumulative abnormal returns) between 2.23% and 2.62% over a six-year period after a merger. Asquith (1983) finds that acquiring firms CAR decreases by 7.2% in one-year following the completion of mergers. Malatesta (1983) finds a statistically significant CAR of 7.6% one-year after the merger announcement. Jensen and Ruback (1983), who survey seven studies, report an average CAR of 5.5% one-year after the merger. Magenheim and Mueller (1988) report a significant CAR of -2.4% in three-year after the merger. Lahey and Conn (1990) find a significant threeyear CAR of 10.2% and 38.57% respectively relative to two benchmarks. Agrawal, Jaffe and Mandelker (1992), in a comprehensive analysis of the post-merger stock performance use a large sample of mergers over a 30-year period. They find that acquiring firms suffer a statistically significant wealth loss of about -10% over a fiveyear post-merger period. Anderson and Mandelker (1993) also find significant five-year CARs of 9.6% and 9.3% under a size and a size and book-to-market adjustment model respectively. Loughran and Vijh (1997) report a statistically significant five-year BHAR (buy-and-hold abnormal return) of 15.9% following mergers relative to a size and book-to-market adjusted benchmark. Finally, Rau and Vermaelen (1998) use the
3

We note here that other studies, for example, Bradley and Jarrell (1988), Franks, Harris and Titman (1991) do not find significant underperformance up to three years after the merger.

size and book-to-market adjustment method and report a statistical significant three-year CAR of 4%. Most recently, in a review paper, Agrawal and Jaffe (2000) conclude that the long-run post merger stock performance is significantly negative.

Since we use UK merger data we also provide a brief review of prior research on postmerger stock price performance of UK firms. Barnes (1984) and Dodds and Quek (1985), for example, report CARs of 6.3% and 6.8% respectively over the five-year period following a merger announcement. Franks and Harris (1989), use a large comprehensive sample of 1,800 UK mergers between 1955-1985 and find that acquiring firms suffer significant wealth loss in two- year (CAR = -12.6%) after the merger completion. Limmack (1991), uses three benchmarks, also finds that all benchmarks produce significant negative CARs in the two-year period after the mergers, with an average CAR of 9%. Further, Limmack and McGregor (1995) also find a significant negative two-year CAR of 14.1%. Gregory (1997), uses six benchmarks, and finds that the two-year CARs are significant and between 11.8% to 18%. Chatterjee (2000) and Aw and Chatterjee (2004), use the market model, and find significant negative threeand two-year CARs of 35.3% and 10.44% respectively. A general conclusion from these studies using UK data, is similar to that seen for the US market; there is statistically significant underperformance following the merger when using traditional event study metrics.

We sum up this review by noting that the study of long-horizon abnormal returns has almost exclusively use measures of performance and statistical tests of these that rely on the standard event study methodology. However, as Lyon, Barber, and Tsai (1999) note,

the measurement problems in this approach are treacherous and the econometric problems make inference difficult. In addition, recent work by Schultz (2004) and Viswanathan and Wei (2004), casts doubt on whether event study methodology would be able to resolve the issue of long-term abnormal performance. In this paper therefore we turn to an alternative approach and use stochastic dominance to study the relative performance, over long horizons, between merger portfolios and benchmark portfolios.

3. Data and Methodology

3.1. Data

We study a sample 305 successful public mergers by UK firms from 1985 to 20004. Our sample is drawn from the Securities Data Corporation (SDC) using the following criteria: (1) All acquiring and target firms are UK public firms; (2) The deal value of the merger is over one million US dollars5; (3) Excluding financial and utility firms; (4) Bidders acquire at least 50% of the targets in obtaining an absolute control. In addition, acquiring firms monthly stock prices, size (market value), and book-to-market ratios are obtained from Thomson Financial Datastream. Following Lyon, Barber, and Tsai (1999), sample firms with negative book value of equity are excluded. We also obtain data regarding the method of payment and the one-month merger premium6 from the

1985 is the earliest year for which UK M&A data is available in the Securities Data Corporation (SDC) database. 5 We follow the literature (see for example Fuller, Netter, and Stegemoller, 2002 and Moeller, Schlingemann and Stulz, 2004 a,b) and use a one million dollars cut-off point so as to exclude very small deals. 6 Evidence shows that target firm share prices only change significantly at merger announcement date and the day before. Thus the use of one-month merger premium can reflect the true difference between offer price and targets normal price. See, for example, Dodd (1980), Asquith (1983), Dennis and McConnell (1986), Huang and Walkling (1987), and Bradley and Jarrell (1988). The one-month merger premium

SDC. Our final sample consists of 305 UK public acquiring firms selected from the intersection of the above databases. We then sort the sample firms into portfolios based on the following criteria: the one-month merger premium, the method of payment, and value/glamour acquirers.

We construct the merger and benchmark portfolios as follows. For a given acquirer, we find a single control firm that has the closest size and book-to-market ratio as the acquiring firm. For a given merger, we calculate the acquiring and benchmark firms three-year buy-and-hold returns (BHRs) from the month immediately after the merger completion. After obtaining all the BHRs for our sample and benchmark firms, we then partition these into portfolios based on the following criteria: one-month merger premium, the method of payment, and value/glamour acquirers.

We present in Tables 1 and 2 some descriptive statistics of our sample. We report, in Table 1, the number of mergers, the proportion of firms under different method of payment, and the average merger premiums at each calendar year from 1985 to 2000. We note that that cash payment (44%) is the major financing method with evenly divided stock and mixed payment. Further, the one-month merger premiums range from 30% to 56% with an average of 43%. In Table 2, we report sample statistics for the sample firms BHR, control firms BHR, and sample-control BHAR. As can be seen, the mean, median, and standard deviations are quite similar between the sample firm BHR and the control firm BHR.

equals to the difference between the initial bid price and target market price four weeks before the initial merger announcement divided by the same target price four-week prior to the announcement.

3.2. Methodology

We first begin with a brief description of stochastic dominance relations as applied in our specific context to compare the buy-and-hold return distributions from a merger portfolio and a size and book-to-market matched benchmark portfolio. Next we describe the statistical tests used in our empirical work.

Decision making under uncertainty concerns the choice between random payoffs and is an important topic in economics and finance. The idea of stochastic dominance offers a general decision rule provided the utility functions share certain properties. Specifically, we study whether, given preferences like non-satiation or risk aversion,7 one random variable (in our case buy-and-hold return distribution of a merger portfolio) dominates a benchmark portfolio that are commonly used in assessing post-merger performance. In other words we investigate whether an investor with specific preferences prefers a portfolio of acquiring firms relative to an investment in a benchmark portfolio. We do this by comparing whether the buy-and-hold return distribution of payoff to the merger portfolio stochastically dominates the buy-and-hold return distribution of a benchmark portfolio.

We compare the buy-and-hold return distributions of our two candidate portfolios using the first two orders of stochastic dominance. These are defined as follows. A cumulative distribution function G is said to first- and second-order stochastically dominate a cumulative distribution function distribution F if:
7

The stochastic dominance approach allows for a more general framework than one that uses only the mean and the variance as measures of comparative risk since these imply that the utility function is quadratic or the distribution of payoffs is normal.

1 ( z ; G ) 1 ( z ; F ) ,
2 ( z; G ) 2 ( z; F ) ,

(1) (2)

where z is the joint ordered data points of the two samples and where:
1 ( z; F ) = F ( z ) ,
2 ( z; F ) = F (t ) dt = 1 (t ; F ) dt ,
0 0 z z

(3) (4)

I1(z;G) and I2(z;G) are analogues of Equation (3) and (4) in the case of the cumulative distribution function G.

We rely, in this paper, on tests for detecting stochastic dominance described in Barrett and Donald (2003). The test compares the two candidate cumulative distribution functions distributions at all points in the sample.8 The null hypothesis, in these tests, is that cumulative distribution function G stochastically dominates cumulative distribution function F for the jth order (this hypothesis also includes the case where the two distributions are equal everywhere) while the alternative is that stochastic dominance fails at some points. These hypotheses can be more compactly written as: H0: j ( z;G) j ( z; F ) for all z , H1: j ( z; G ) > j ( z ; F ) for some z . The Barrett and Donald (2003) test statistic is:
= S j NM ) ( z; F )) , sup ( j ( z; G M j N N +M z

(5) (6)

(7)

where the operator Ij are given by:

8

Several tests proposed earlier (for example Anderson, 1996 and Davidson and Duclos, 2000) compare the distribution functions only at a fixed number of arbitrarily chosen points. In general, comparisons using only a small number of arbitrarily chosen points will have low power if there is a violation of the inequality in the null hypothesis on some subinterval lying between the evaluation points used in the test.

 )= j ( z; F N

1 N 1 N 1 j ( z;1X i ) = 1( X i z )( z X i ) j 1 , N i =1 N i =1 ( j 1)!

(8)

)= 1 j ( z; G M M

i =1

( z;1Yi ) =

1 M

( j 1)!1(Y
i =1

z )( z Yi ) j 1 .

(9)

The test statistics for stochastic dominance beyond the first order (e.g. second-order stochastic dominance) do not have closed-form limiting distributions. As a result, pvalues need to be obtained by simulation (see also McFadden, 1989). Barrett and Donald (2003) propose two methods to obtain simulated p-values; by simulation and by bootstrapping.

The first test statistic (KS1) using simulation to obtain the exact p-values is:
)) . S jF = sup ( j ( z; * F N
z

(10)

The second test statistic (KS2) is:

( z; * G ) ( z; * F )) , S jF ,G = sup( 1 j M j N
z

(11)

= N (N + M ) . where

In both cases, the probability that a test statistic using random variables exceeds that using the empirical sample is computed using simulation. The approximate p-values and the decision rules for rejecting the null hypotheses are:
1 R ) < , Reject H0 if p F 1(S jF,r > S j j R
r =1

(12)

1 R ,G ) < , Reject H0 if p F 1( S jF,r,G > S j j R

r =1

(13)

10

where R is the number of replications used in the simulation, and is the specified significance level.

The other method to obtain exact p-values used by Barrett and Donald (2003) tests is the bootstrap. An advantage of the bootstrap relative to the multiplier method is that we now do not necessarily need to characterize the distribution. We follow Barrett and Donald (2003) and use three different bootstrapped-based simulation methods. The first test statistic (KSB1) using the bootstrap is:
* ) ( z; F )) , S jF,b = N sup ( j ( z; F N j N
z

(14)

* ) is the analogue of Equation (8) for a random sample of size N drawn where j ( z; F N

from = { X 1 ,..., X N } .

The second test statistic (KSB2) using the bootstrap is:

G S jF,b,1 =

N M * ) ( z; F * )) , sup( j ( z; G M j N N +M z

(15)

* ) is the analogue of Equation (9) for a random sample of size M drawn where j ( z; G M

* ) is the analogue of from the combined sample = { X 1 ,..., X N , Y1 ,...,YM } , and j ( z; F N

Equation (8) for a random sample of size N drawn from the combined sample
= { X 1 ,..., X N , Y1 ,..., YM } .

Finally, the third test statistic (KSB3) using the bootstrap is:
S jF,b,G 2 = NM * ) ( z; G )) ( ( z; F * ) ( z; F ))) , sup(( j ( z; G M j M j N j N N+M z

(16)

11

 * ) is the analogue of Equation (9) for a random sample of size M drawn where j (z;G M
* ) analogue of Equation (8) for a random from the sample = {Y1,...,YM } , and j ( z; F N

sample of size N drawn from the sample = { X 1 ,..., X N } . In this case the two draws are independent.

In each of the three bootstrap-based simulation methods described above, we are interested in computing the probability that the test statistic using random variables exceeds the value of the test statistic using the empirical sample. The exact p-values and the decision rules for rejecting the null hypotheses in the case of KSB1, KSB2, and KSB3 respectively are:
1 R ) < , Reject H0 if ~ pF 1(S jF,b,r > S j ,b j R
r =1

(17)

1 R ,G ) < , Reject H0 if ~ pF 1(S jF,b,1G,r > S j ,b1 j R

r =1

(18)

1 R ,G Reject H0 if ~ , pF 1(S jF,b,G j ,b 2 2,r > S j ) < R

r =1

(19)

where R is the number of replications used in the bootstrap simulation, and is the specified significance level. To sum up, we use two test statistics using simulation and three that use bootstrapping to obtain the p-values used to test for various orders of stochastic dominance. In the case of first-order stochastic dominance since an analytic solution is available we are not required to use either simulation or bootstrapping to obtain the exact p-value9.

Ho (2003) is a recent example of an application of stochastic dominance tests to evaluate IPO long-run performance.

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4. Empirical Results

We now turn to the results of our statistical tests for stochastic dominance relations between the merger portfolios and a set of benchmark portfolios using three-year buyand-hold returns (BHRs). We report results based on the comparison of the entire distribution of three-year BHRs of portfolios of merger firms relative to benchmark firms using equally weighted portfolios following the literature reviewed earlier. In the Tables, we do not report p-values but instead report only the qualitative conclusion for ease of interpretation using a 5% level of significance.

4.1. Results of the Full Sample and Subsample Periods

We present, in Table 3, results of our tests for first- and second-order stochastic dominance between the merger portfolio and benchmark portfolio returns. Our tests follow a two-step procedure: First, we test the null hypothesis as to whether the benchmark portfolio stochastically dominates the merger portfolio return. Second, we report p-values of tests for the converse hypothesis, i.e. whether the merger portfolio stochastically dominates the benchmark portfolio. The results of our statistical tests can be interpreted as follows: If we fail to reject the null in the first step that the benchmark portfolio stochastically dominates the merger portfolio but reject the null in the second step that the merger portfolio stochastically dominates the benchmark portfolio, we can then conclude that the benchmark portfolio stochastically dominates a merger portfolio.10 However if we reject or fail to reject both steps of the test, we can only
10

Alternately, if we fail to reject in the second step that the merger portfolio stochastically dominates the benchmark portfolio but can reject in the first step that the benchmark portfolio stochastically dominates

13

conclude that there is no stochastic dominance relation between the two portfolio returns.

We begin with our results of tests for first-order stochastic dominance (FOSD). We find that, during the full sample period (1985-2000), there is no evidence of a FOSD relation between the merger portfolio and a size and book-to-market matched benchmark portfolio. During the two sub-sample periods (1985-1990 and 1991-2000), we also find similar results. These results imply that investors, who prefer more wealth to less (i.e., for the case of FOSD), would be indifferent between a merger portfolio and a size and book-to-market matched portfolio. These results contrast with those obtained comparing only the mean portfolio returns as in a standard event study methodology. Comparison of the mean alone may not fully reflect the difference between the merger portfolio and the benchmark portfolio for investors who prefer more wealth to less.

We next report results of our tests for second-order stochastic dominance (SOSD) between the merger portfolios and the benchmark portfolios. As Table 3 shows we find no evidence of any second order stochastic dominance relation between the merger portfolios and benchmark portfolios for both the full sample and two subsamples. Our results imply that an investor, who is risk-averse, would still be indifferent between a merger portfolio and a benchmark portfolio.

We find, in contrast to most previous studies, that there is no evidence that acquiring firms significantly underperform in three years after mergers based on tests of both first-

the merger portfolio, we conclude that there is a stochastic dominance relation of merger portfolio over the benchmark portfolio.

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and second-order stochastic dominance. Our findings are in line with some of most recent studies11 that argue that the conventional event study method may not reliable due to a bad model problem (see for example, Fama, 1998) and possible misspecification of the conventional test statistic used in long-run event studies that too often leads to the over-rejections of the null hypothesis.

4.2. Test of Overpayment Hypothesis

A popular explanation of the widely documented long-run post merger underperformance of acquiring firms is that it represents a delayed market reaction to overpaid mergers. In other words, acquirers may have paid higher premiums than warranted for targets, leading to a delayed price correction in their post merger period. There are several possible reasons for such overpayment in mergers. For example, the conflict of interest hypothesis states that acquirer management will engage in activities that benefit themselves even if they reduce shareholders wealth (Jensen and Meckling, 1976; Fama, 1980; Fama and Jensen, 1983; and Jensen, 1986). It predicts that acquirer management will knowingly overpay for target firms. On the other hand, the hubris hypothesis states that managers of acquiring firms might be too optimistic about their past performance and the perceived synergy of the merger. These managers believe that they could improve the performance of the acquired firms sufficiently to recoup the higher premiums offered (Roll, 1986). Relying on this literature, we test the following hypothesis: If overpayment is responsible for acquirers long run

See for example, Barber and Lyon (1997), Kothari and Warner (1997), Fama (1998), Lyon et al (1999), and Viswanathan and Wei (2004).

11

15

underperformance, the higher the premium paid the worse would be the acquirers long-run post merger performance.

We now report, in Table 4, results of our tests for first-order and second-order stochastic dominance relation between each of the benchmark portfolios and merger portfolios sorted by one-month merger premiums. As can be seen from the Table, there is no FOSD relation between the low- and medium-premium merger portfolios and their respective size and book-to-market matched benchmark portfolios. This finding suggests that investors who only prefer more wealth to less would be indifferent between the low- and medium merger portfolios and the respective benchmarks. However, we find that the benchmark portfolio marginally stochastically dominates the high-premium merger portfolio. This result implies that investors who only prefer more wealth to less would prefer a size and book-to-market matched benchmark portfolio than the high-premium (i.e., the excessively overpaid) merger portfolio.

Our results for tests of second-order stochastic dominance (SOSD) relation mirror the findings of first-order stochastic dominance (FOSD). Our results suggest that riskaverse investors are indifferent between the low- and medium-premium merger portfolios and the respective benchmarks, while they would prefer a size and book-tomarket matched benchmark relative to a high-premium merger portfolio. Thus, it is clear that, under both FOSD and SOSD, acquiring firms that have paid highest premiums to the targets underperform their size and book-to-market matched peers. Our results suggest therefore that overpayment may be a possible reason for the documented long-run post merger underperformance of acquiring firms.

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4.3. Test of Method of Payment Hypothesis

The method of payment in mergers has various valuation effects and can signal important information of the true value of acquiring firm under asymmetric information. Myers and Majluf (1984), for example, show that the use of equity can convey unfavourable information. The intuition for this idea is that if managers are better informed than the market, they will tend to pay mergers by stock if they believe their stock is overvalued and use cash otherwise. Further, cash offer allows the acquiring firms current shareholders to retain all of the future (positive) returns. Stock offer, on the other hand, shifts part of the (possibly negative) future returns to the new shareholders. Thus, cash payment is widely interpreted as a release of positive Further, Jensen (1986)

information while stock payment as negative information.

argues that the use of cash in financing takeovers can increase firms value by obviating potential agency problems associate with excessive retention of free cash flows. 12 Hence, on average, the long-run performance of stock-financed mergers will be negative and positive to cash-finance mergers 13 under the prediction of either information signalling or agency costs.

We now present, in Table 5, results of our tests for first-order and second-order stochastic dominance relation between merger portfolios sorted by method of payment and each of the benchmark portfolios. We find that a cash-financed merger portfolio

Hansen (1987), Fishman (1989), and Eckbo, Giammarino, and Heinkel (1988) also argue that the choice of method of payment in takeovers may be partially driven by agency cost considerations. 13 See for example, Wansley, Lane, and Yang (1983), Travlos (1987), Huang and Walkling (1987), Eckbo (1988), Eckbo, Giammarino, and Heinkel (1988), Asquith, Brunner, and Mullins (1988), Franks, Harris, and Mayer (1988), Limmack and McGregor (1995), Loughran and Vijh (1997), and Rau and Vermaelen (1998).

12

17

marginally stochastically dominates the benchmark portfolio in the first order. In other words investors, who only prefer more wealth to less, would favour a portfolio of cashfinanced acquirers than the benchmark portfolio. However, we find no FOSD relation between a stock-financed portfolio and the benchmark portfolio. This implies that investors, who only prefer more wealth to less, would be indifferent between a portfolio of stock-financed acquirers and the benchmark. Our results for tests of second-order stochastic dominance (SOSD) relation remain unchanged for these two sets of portfolios. Our overall results suggest that risk-averse investors would prefer a cashfinanced merger portfolio than a benchmark portfolio but are indifferent between a stock-financed merger portfolio and the benchmark. Thus we find that, under both FOSD and SOSD, acquiring firms using cash payment outperform their size and bookto-market matched peers in three years after the merger. This evidence is consistent with the results reported in previous studies. However, contrary to past evidence, we do not find that stock-financed acquirers underperform the benchmark firms in the long run.

4.4. Test of Performance Extrapolation Hypothesis

The performance extrapolation hypothesis (e.g., Rau and Vermaelen, 1998) posits that the market over extrapolates the past performance of acquirer when it assesses the value of a merger. Thus, glamour acquirers (low book-to-market ratios) are more likely to be infected by hubris (Roll, 1986) and tend to be overconfident about their ability to manage a merger. Indeed, Lakonishok, Shleifer, and Vishny (1994) find that glamour firms are typically with high past stock returns and high past growth in cash flows and

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earnings, which will presumably strengthen the managements belief about their ability to handle the merger. On the other hand, value acquirers (high book-to-market ratios) are more prudent for a merger and hence more likely to create value for shareholders. Rau and Vermaelen (1998) find that value acquirers outperform glamour acquirers in the three years period after the merger with value acquirers earn significant positive abnormal returns of 8% while glamour acquirers lost a significant 17% in three years after the merger. It is therefore interesting to look at the performance extrapolation hypothesis from a stochastic dominance perspective.

We present, in Table 6, results of our tests for first-order and second-order stochastic dominance relation between merger portfolios sorted by book-to-market ratios (i.e., value or glamour acquirers) and each of the benchmark portfolios. We find no evidence of any FOSD relation between the glamour acquirer portfolio and the benchmark portfolio. Our results suggest that investors, who only prefer more wealth to less, would be indifferent between a portfolio of glamour acquirers and the benchmark. The same result also holds true for value acquirer portfolio. Our results for tests of second-order stochastic dominance (SOSD) relation are similar to the tests for the first-order stochastic dominance (FOSD). These results suggest that risk-averse investors would be indifferent between the glamour acquirer portfolio and the benchmark, and between the value acquirer portfolio and the benchmark. Thus in contrast to Rau and Vermaelen (1998), our results based on both FOSD and SOSD show that, glamour acquirers do not significantly underperform their size and book-to-market matched peers. We therefore give little support to the performance extrapolation hypothesis based on our tests of stochastic dominance.

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5. Summary and Conclusions

In this paper, we re-visit the long-run post merger performance of acquiring firms by using stochastic dominance to compare portfolio return distributions. Specifically, we compare whether an investor, given an ex ante choice of a benchmark portfolio, prefers the benchmark portfolio to a portfolio of acquiring firms on the basis of statistical tests for stochastic dominance.

Our main results are as follows. First, we observe no evidence of a first- or secondorder stochastic dominance relation between the merger portfolios (for both the full sample and two subsamples) and their respective benchmark portfolios matched on both size and book-to-market ratios. Our result contrast with previous research, that relies on an event study approach to measure relative performance and reports long-run underperformance following mergers. Our results are consistent with the evidence of no underperformance reported by Bradley and Jarrell (1988), and Franks, Harris, and Titman (1991). Second, we find that the benchmark portfolio stochastically dominates the merger portfolio of acquirers that paid highest merger premiums to the target firms. This result suggests that overpayment may be a possible reason for the long-run underperformance of some acquiring firms. Third, we find that cash-financed merger portfolio clearly dominates the benchmark portfolio while there is no evidence of a stochastic dominance relation between the stock-financed merger portfolio and our benchmark portfolio. Our result is consistent with previous evidence that cash-financed mergers outperform the stock-financed ones. Finally, in contrast to some recently evidence (e.g., Rau and Vermaelen 1998), we do not find the stylized value/glamour

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effect in mergers since we find no evidence of a stochastic dominance relation between value/glamour portfolio and the benchmark portfolio.

We note, in conclusion that many issues make the measurement of abnormal performance over long horizons difficult. These include, identification of benchmark models, the use of buy-and-hold versus cumulative abnormal returns, the use of valueversus equal-weighted portfolios, corrections for cross-correlations in event time returns, accounting for time variation in risk over the event window and the nonnormality of long-run abnormal returns. Recently doubts have been expressed over whether event studies can be a useful tool to measure long-run performance in respect of events like mergers that are endogenous. Our paper is a first step to use an alternate methodology that throws some more light on evaluating post-merger performance over the long run. Further research is needed therefore to develop methods that control for the various biases in measuring long-run abnormal performance so that we can understand whether post-merger underperformance is really a puzzle or merely a statistical artifact of the data. We leave these interesting and important issues for future research.

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Table 1. Descriptive statistics for mergers between 1985-2000 The sample consists 305 U.K. public acquiring firms with a deal value of one million dollars or more. There are three methods of payment for the merger: pure cash, pure stock, and mixed. The mixed payment subset includes all mergers in which the method of payment is neither pure cash nor pure stock. The merger premium is defined as the four-week pre-announcement premium. It equals to the difference between the initial bid price and target market price four weeks before the initial merger announcement divided by the same target price four-week prior to the announcement. It shows the number of mergers, the proportion of different method of payment, and the average merger premium in each calendar year. Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 All Firms 4 3 19 29 34 16 18 9 12 14 24 14 20 32 37 20 305 Cash (%) 50 33 21 66 35 50 44 22 25 43 46 36 40 50 41 40 44 Stock (%) 25 67 53 17 35 25 22 22 25 29 25 36 45 25 22 30 29 Mixed (%) 25 0 26 17 29 25 28 56 42 29 29 29 15 22 38 30 27 Premium (%) N/A 43 40 36 40 56 44 30 55 46 34 31 53 38 40 50 43

Table 2. Descriptive statistics for sample and matching portfolios three-year stock returns The sample consists 305 U.K. public acquiring firms with a deal value of one million dollars or more. Sample firms are matched with control firms with the closest size and book-to-market ratio. BHR is the three-year buy-and-hold return. BHAR is the three-year buy-and-hold abnormal return. We present for each portfolio the mean, median, standard deviation (SD), minimum, and maximum of its BHRs. Mean Sample Firm 0.9616 BHR Matching Firm 0.9571 BHR Sample-Matching 0.0045 BHAR Median 0.8543 0.8741 -0.0198 SD 0.7460 0.6859 0.1120 Min -0.3251 -0.3675 0.0424 Max 5.3789 4.0712 1.3077

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Table 3. The Stochastic Dominance Relation between Merger Portfolios and Benchmark Portfolios In this table we report the first-order and second-order stochastic dominance relation between the equal-weighted three-year buy-and-hold merger portfolios of the full sample and two subsamples and each of the size and book-to-market matched benchmark portfolios. B means benchmark portfolio stochastically dominates merger portfolio; M means merger portfolio stochastically dominates benchmark portfolio; N means no stochastic dominance relation between the two portfolios. We use a 5% significance level as a criterion. BD Test is the Barrett and Donald test. 1985-2000 BD Test First-Order Second-Order N N 1985-1990 N N 1991-2000 N N

Table 4. The Stochastic Dominance Relation between Merger Portfolios and Benchmark Portfolios Sorted by Merger Premium In this table we report the first-order and second-order stochastic dominance relation between the equal-weighted three-year buy-and-hold merger portfolios of the full sample sorted by merger premium and each of the size and book-to-market matched benchmark portfolios. The merger premium is defined as the four-week pre-announcement premium. It equals to the difference between the initial bid price and target market price four weeks before the initial merger announcement divided by the same target price four-week prior to the announcement. Acquiring firms are ranked against their merger premiums and partitioned into three portfolios according to their rankings. Low premium portfolio consists the low 30% firms. Medium premium portfolio consists the middle 40% firms. High premium portfolio consists the high 30% firms. B means benchmark portfolio stochastically dominates merger portfolio; M means merger portfolio stochastically dominates benchmark portfolio; N means no stochastic dominance relation between the two portfolios. We use a 5% significance level as a criterion. BD Test is the Barrett and Donald test. Low Premium N N Medium Premium N N High Premium B (Marginal) B

BD Test First-Order Second-Order

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Table 5. The Stochastic Dominance Relation between Merger Portfolios and Benchmark Portfolios Sorted by Method of Payment In this table we report the first-order and second-order stochastic dominance relation between the equal-weighted three-year buy-and-hold merger portfolios sorted by method of payment and each of the size and book-to-market matched benchmark portfolios. There are three methods of payment for the merger: pure cash, pure stock, and mixed. The mixed payment subset includes all mergers in which the method of payment is neither pure cash nor pure stock. B means benchmark portfolio stochastically dominates merger portfolio; M means merger portfolio stochastically dominates benchmark portfolio; N means no stochastic dominance relation between the two portfolios. We use a 5% significance level as a criterion. BD Test is the Barrett and Donald test. Cash BD Test First-Order Second-Order M (Marginal) M Stock N N Mixed B N

Table 6. The Stochastic Dominance Relation between Merger Portfolios and Benchmark Portfolios Sorted by Book-to-Market Ratio In this table we report the first-order and second-order stochastic dominance relation between the three-year buy-and-hold merger portfolios sorted by book-to-market ratio and each of the size and book-to-market matched benchmark portfolios. Acquiring firms are ranked against their book-to-market ratio and partitioned into three portfolios according to their rankings. Low book-to-market portfolio (glamour portfolio) consists the low 30% firms. Medium book-tomarket portfolio consists the middle 40% firms. High book-to-market portfolio (value portfolio) consists the high 30% firms. B means benchmark portfolio stochastically dominates merger portfolio; M means merger portfolio stochastically dominates benchmark portfolio; N means no stochastic dominance relation between the two portfolios. We use a 5% significance level as a criterion. BD Test is the Barrett and Donald test. Low B/M (Glamour) BD Test First-Order Second-Order N N

Medium B/M N N

High B/M (Value) N N

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