Project 1

Mergers and Acquisitions

(Theories and Evidence)
The objectives of the session

At the end of the session you should be able to

understand:
The commonly cited rationale for M&A,
Empirical evidence on whether M&A creates value to the
shareholders of targets and acquirers,
The factors that are known to affect the gains from M&A
to acquirers what the evidence says on their role.

Overall, it offers a sound theoretical base for you to

complete your project 1.

Mergers and Acquisitions 2

The Concept
Merger: Absorption of one company by another.
Horizontal: Both firms operate in the same industry.
Vertical: Firms operate in complementary line of
business.
Conglomerate: Firms operate in different industry.

Tender offers: Bidder makes offer to shareholders of

target.

Consolidation: A new firm is formed from merger of two.

Asset acquisitions: Assets of target are purchased by

acquirer.

Mergers and Acquisitions 3

Reasons for Mergers and Acquisitions

Agency
issues

Tax Signallin
benefits g
Why
manage
rs opt
for
M&A? Efficienc
Diver- y and
sification Synergy
Earning
s
growth

Mergers and Acquisitions 4

Reasons for Mergers and Acquisitions
1. Efficiency and Synergy:
Synergy = VXY (VX + VY); value is added if synergy > 0.
Sources of synergy gains:
Cost reduction:
Economies of scale,
Complimentary resources,
Elimination of inefficiencies.
Revenue enhancement:
Improved marketing,
Combining relevant technology,
Enhanced market share or monopoly (some
regulatory provisions may restrict monopoly creation
though).

Mergers and Acquisitions 5

Reasons for Mergers and Acquisitions
2. Signalling: Undervalued firms may bid for a target with a
view to disseminate value enhancing information.
Assumptions include:
Managers want to reveal value enhancing information.
New information pushes bidders price to equilibrium.

3. Agency issues:
Managerial compensation depends largely on firm size.
Hence, managers may acquire targets (to expand) even if
the deal does not add value to shareholders wealth.
Managers of firms with excess cash may be tempted in
making bids.

4. Tax benefits: Sources of tax benefits from merger include:

A tax-paying bidder may acquire a target with
accumulated tax losses (if tax law allows).
Bidder
and
Mergers acquires a target with unused debt capacity. The 6
Acquisitions
Reasons for Mergers and Acquisitions
Some Dubious Reasons for Merger:
5. Diversification: Some argue that conglomerate
mergers can reduce earnings volatility because of
diversification and hence enhance firm value.
However, shareholders can buy the shares of both firms
and reduce volatility. Hence, diversification through
mergers should not add value.
Could there be any exception to this home-made
diversification?

6. Earnings Growth: Enhancing growth in EPS is cited as

a reason. Firm with low EPS bids for a firm with high EPS.
When earnings are combined the EPS of the bidder
increases.
However, this should add no value, no additional income
is generated.
Mergers and Acquisitions This adds value only if the market can be 7
Mergers and Value Creation
Do target company shareholders gain?
Empirical evidence (Jensen and Ruback, 1983, and Draper
Paudyal, 1999) suggest that shareholders of target
companies gain abnormal returns on the announcement
of deals. Usually reported gain is around 15% of pre-event
market price.

Draper and Paudyal

(1999) show that
(figure on the left)
target firms gain
more than the
bidders.

Mergers and Acquisitions 8

Mergers and Value Creation
Do acquirers gain on the announcement of bid?
Empirical studies (for example, Jensen and Ruback, 1983,
and Draper Paudyal 1999) show that bidders either
breakeven or suffer a small loss.
What are the possible reasons?
Benefits anticipated by bidder managers are unlikely to
be achieved. Market may perceive that managers are
overoptimistic (managerial hubris).
The bid was possibly guided by managers empire
building interest.
The synergy gain is too small to affect bidders value
because of the difference in the size of the bidder and
target.

Mergers and Acquisitions 9

Mergers and Value Creation
Do acquirers benefit in the long-run?
Agrawal et al. (1992) and Loughran and Vijh (1997) suggest
that average US acquirer suffers a loss in the long-run.
Gregory (1997) and Ekkayokkaya, Holmes and Paudyal
(2009) show that UK bidders lose in the long run while Higson
and Elliott (1998) suggest that they break-even.
Ekkayokkaya, Holmes and Paudyal (2009) further show that
the long-term loss is largely driven by the experience of
unlisted target acquirers. The acquirers of listed targets
break-even until 3-years after the completion of the deal.
Overall, the evidence on the long-term performance of
acquirers is mixed.

Mergers and Acquisitions 10

Factors Affecting Bidders Gains
The factors that are known to affect bidders gains include:
Methods of Payment (cash, shares, and mixed):
Cash financed acquisitions do better than share financed deals.
Cash financed tender offers generate very high excess return while
cash financed mergers suffer a loss.
Bidders lose on share deals; more so in tender offers than in
mergers.
Why should the method of payment matter?

Draper and Paudyal

(1999, figure on the
left), show that cash
deals outperform
share deals.

Mergers and Acquisitions 11

Factors Affecting Bidders Gains
Methods of Acquisition (mergers vs. tender offers):
Loughran and Vijh (1997) show that the US firms involved
in mergers loose in the long-run.
Agrawal et al. (1992) show that acquirers suffer a loss in
mergers but break-even in tender offers in the long-run.
Rau and Vermaelen (1998) show that acquirers in mergers
suffer a loss while acquirers in tender offers earn gain
positive abnormal returns in the long-run.
Most studies agree that the bidders involved in tender offers
do not loose significantly in long-term, sometimes they gain
but bidders suffer a loss in mergers.

Why should the method of acquisition matter?

Mergers and Acquisitions 12

 Factors Affecting Bidders Gains
Listing Status of Target (listed and unlisted)
Bidders of unlisted targets gain more than the acquirers of listed targets (e.g.
Draper and Paudyal, 2006 and Faccio et al., 2006). The possible reasons
include:
The managerial motive (empire building vs. shareholders wealth
maximisation)
The unlisted target are less liquid than listed targets
The bargaining power of unlisted target owners is limited
Bidders of unlisted targets gain the most on share deals. Why?
The corporate monitoring hypothesis
The asymmetric information hypothesis

Draper and Paudyal

(2006, figure on the
left) confirm that
unlisted target
acquirers gain more
than acquirers of listed
targets.
Mergers and Acquisitions 13
Factors Affecting Bidders Gains
Bidders Information Asymmetry and Pre-bid
valuation:
Draper and Paudyal (2008) confirm that on the
announcements of bids undervalued bidders gain the
most (see the figure below).
This is because the news draws the attention of market
and analysts leading to a reduction in information
asymmetry and revaluation of the bidder.
The announcement period gains include revaluation as
well as synergy gains.
Note the interaction
between pre-bid
valuation (Low-V and
High-V) and information
asymmetry (Low-IA and
High-IA).

Mergers and Acquisitions 14

Factors Affecting Bidders Gains
Growth opportunities of bidders (value vs. glamour):
Rau and Vermaelen (1998) suggest that glamour (high
MTBV) bidders should gain more on bid announcement
while value (low MTBV) bidders should gain more in the
long run.
Draper and Paudyal (2008) confirm that glamour bidders
gain more than value bidders on the announcement of bids.
Rau and Vermaelen (1998) show that value bidders
outperform glamour bidders in the long-run.
The long-term underperformance of acquiring firms in
mergers is predominantly caused by the poor post-
acquisition performance of glamour firms (Rau and
Vermaelen, 1998).

Mergers and Acquisitions 15

Factors Affecting Bidders Gains
Industry affiliation of bidder and target (diversifying vs.
focused):
Diversification is one of the commonly cited reasons for
conglomerate merger. However, evidence show that firms
engaged in diversifying acquisitions suffer a loss in share
prices and operating performances.
Draper and Paudyal (2008) also show that bidders gain more
from focused deal than from diversifying deals.
Ekkayokkaya and Paudyal (2009, figure below) show that the
Acquirers'
gains from Gains from Diversifying
diversifying dealsDeals
depend on the pre-bid
diversification level of acquirer.
1.50%
1.00% There is a trade-off between
0.50%
the gains from risk
Acquirers' Gains 0.00%
-0.50% reduction and managerial
constraints.

Number of pre-bid segments

Mergers and Acquisitions 16

Factors Affecting Bidders Gains
Domicile of targets (foreign vs. domestic)
Acquirers of foreign targets gain from technological
advancements, business diversification, and market
imperfections. However, they are also exposed to foreign
exchange, political and economic risks.
Studies by Moeller and Schlingemann (2005) and Draper
and Paudyal (2008) show that acquirers of domestic targets
gain more than the acquirers of foreign targets.
Gregory and McCorriston (2005) suggest that the gains
from foreign target takeovers depend on the country in
which the target is domiciled.
Barbopoulos, Paudyal and Pescetto (2009) show that UK
acquirers gain the most from the acquisitions of targets
based in civil-law countries.

Mergers and Acquisitions 17

Factors Affecting Bidders Gains
Bidders size
Moeller et al. (2004) and Draper and Paudyal (2008) show
that smaller bidders gain more than the larger bidders.

The figure (Draper

and Paudyal 2008)
also shows that
larger firms
acquire targets
more frequently in
than smaller firms.

Mergers and Acquisitions 18

Factors Affecting Bidders Gains

Other factors include:

Stock market valuation condition: Shleifer and Vishny (2003)
suggest that during high stock market valuation period overvalued
bidders acquire less overvalued targets in share deals and suffer a
loss in the long-run.
Relative size of deal (deal value/market value of bidder):
Bidders earn more from high relative size deals than from low
relative size deals (Draper and Paudyal, 2008). It is possibly
because acquiring relatively larger targets create larger synergy
value which becomes a prominent gain relative to the size of
acquirer.
M&A activities at the time of bid: On the announcement of
deals, acquirers gain higher returns during passive M&A activity
periods than during active M&A periods (Draper and Paudyal,
2008).

Mergers and Acquisitions 19

Finally, Do Mergers and Acquisitions
Create Value?
Draper and Paudyal (1999) show (figure below) that on the
announcement:
Target firms gain,
Acquirers break-even, and
The combined value is positive and significant.

Andrade et al (2001) report similar findings for the US.

Overall, Mergers & Acquisitions create value.
Mergers and Acquisitions 20
Suggested Readings
Journal articles:
Draper, P and K. Paudyal (2008) Information Asymmetry and
Bidders Gains, Journal of Business Finance & Accounting
35, 376-406.
Ekkayokkaya, M., P. Holmes and K. Paudyal (2009) Limited
Information and the Sustainability of Unlisted-Target
Acquirers Returns, Journal of Business Finance &
Accounting 36, 12011227.
Loughran, T. and A. M. Vijh (1997), Do Long-Term
Shareholders benefit from Corporate Acquisitions?, Journal
of Finance 52, 1765-1790.

Mergers and Acquisitions 21