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Review of Quantitative Finance and Accounting

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10-02-2017 | Original Research

Value creation and the probability of success in merger and acquisition transactions

Authors: Yasser Alhenawi, Martha Stilwell

Published in: Review of Quantitative Finance and Accounting | Issue 4/2017

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Abstract

This paper presents and tests a hypothesis that expands existing explanations of value creation in merger and acquisition (M&A) transactions. The main premise is that value creation is determined by not only the target’s pre-acquisition value, as indicated by numerous studies in extant literature, but also by the acquirer’s competency (among other factors) demonstrated by their pre-merger financial ratios. The paper shows that M&A transactions create value in the longer-run and the gain is commensurate with the acquirer’s historical performance and the target’s pre-acquisition value. Further, the paper employs statistical procedures and model-building techniques in order to develop and validate parsimonious Altman-style predictive models. The models reasonably identify successful M&A deals and are statistically significant and consistent with a few existing theories. Specifically, the evidence on liquidity supports internal capital markets hypothesis but does not support the theories of agency problems, while the evidence on financial leverage supports the view that lower debt enhances corporate control.

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Villalonga (2004a, b) documents a diversification premium and shows that diversification discount reported in earlier research is an artifact of sample construction. Others suggest that documented discount is a result of diversifiers’ tendency to acquire business units that are already selling at a discount (Graham et al. 2002; Campa and Kedia 2002).

Hund et al. (2010) use Pastor and Veronesi’s (2003) rational learning model to show that the initial adverse effect of M&A deals is mitigated over time as the segments “learn” to work together. Alhenawi and Krishnaswami (2015) show that M&A transactions erode value initially (consistent with value erosion story) but create value within a 5-year post-acquisition window (consistent with value creation story). They argue that previous work did not take into account the fact that it takes time for firms to realize and fully internalize the synergies of a merger. This is consistent with the view of Barraclough et al. (2013), who used call option prices to analyze market reaction to acquisition announcements and found that market prices tend to underestimate true synergy gains.

Other firm-specific and deal-specific factors as well as the pre-acquisition market value of the target are also included in the analyses.

This is an ex-post analysis but the developed Altman-style models are theoretically sound and statistically verified, which suggests that these models are likely to hold in an ex-ante analysis.

A study by Stevens (1973) uses ratio data and MDA to develop a model that discriminates the acquired group from the non-acquired group. Our work is significantly different in purpose and scope.

In addition, the interpretation of a single ratio is often non-informative unless it is buttressed with simultaneous analysis of other metrics and/or ratios. For instance, a high inventory turnover ratio relative to industry average might indicate highly effective inventory management, which leads to lower cost and higher profitability. However, high inventory turnover could possibly indicate that the firm does not carry adequate inventory, which normally hurts revenues and profitability. In order to discern between the two interpretations, one should look at profitability and cash flow ratios.

Before 1997, firms were required to report their segments as major lines of businesses. After 1997, Statement of Financial Accounting Standards (SFAS) No. 131 requires that segments are defined as the enterprise operating segments, which results in significant changes in reporting procedures (see Rajan et al. 2000). Categorizing segments this way is more representative because it makes divisions of diversified firms closer to pure-play firms used in estimating excess values.

Starting fiscal years ending after December 15, 1977, SEC regulation S-K and SFAS No. 14 requires firms to report audited information for segments whose sales, assets, or profits exceeds 10% of consolidated totals (see more discussions in Berger and Ofek 1995, 1996; Subramaniam et al. 2011).

Sample size in this paper is comparable to that of similar studies such as Ravichandran et al. (2009) who use 403 observations over 6 years; Freund et al. (2007) use 194 acquisitions from 1985 to 1998; Hyland (2003) uses 118 events during the period 1981–1992; Devos et al. (2009) investigates 264 acquisitions. Alhenawi and Krishnaswami (2015) use 316 merger events completed between 1998 and 2007 by 295 acquiring firms. The sample period ends in 2010 in order to allow for analysis of 3 years of post-acquisition performance.

Another methodological approach involves investigating market reaction to merger events by regressing returns on a measure of diversification, such as Herfindahl Index (as in Comment and Jarrell 1995) or by running an abnormal return analysis around divestiture dates (as in Berkovitch and Narayanan 1993; Desai and Jain 1999).

Mathematically, if the probabilities of false allocation of TQ, EVTA, and EVSL are α, β, and γ, respectively, then the probability of false allocation with Z1 and Z2 is $e_{Z} = \alpha \times \beta \times \gamma .$ Since $\alpha ,\;\beta$, and $\gamma$ are less than one, $e_{Z}$ is also less than one, and it is much smaller than $\alpha ,\;\beta$, and $\gamma$. Since the purpose of this study is to develop a predictive model, it is desirable to employ a strict classification. A similar approach is found in Jandik and Lallemand (2014) who classify a target firm as “high performer” if its “operating cash flow to market value of equity” ratio is greater than 1/3 of other firms, and its “average revenue growth” is also greater than 1/3 of other firms in the sample.

EPS is not discussed because it is a function of number of shares.

We compute excess value of the target based on total assets and based on sales. The results in Table 6 were obtained with total assets multiplier. The results with sales multiplier are similar but statistically weaker.

The table presents a few scattered observations that do not line up perfectly with previous findings. For instance, in the regressions of Z1 on $R_{m,4} ,$ PT is statistically significant in the full model and is also present in the reduced model with a negative marginal effect indicating that the probability of success in M&A is reduced when the acquirer exhibit a higher payable turnover ratio. However, PT shows only in the Z1-$R_{m,4}$ model. This observation and the rest of the scattered observations are ignored because they do not show in all models (Wooldridge 2009).

We have also conducted year and industry fixed effect analyses (results are not shown). We found no industry effect and inconsistent year effect (negative in 1998, 2005 and 2006, positive in 2000 and 2008, insignificant in other years). Given that performance is measured within a 3-year post-event window, M&A completed in 1998, 2005, and 2006 might exhibit lower performance because of market downturns in 2000 and 2008. Similarly, positive year effect in 2000 and 2008 might be an artifact of market recovery (see Dimitrov and Tice 2006). Nonetheless, the overall validity of other findings is not sensitive to year and industry effects.

The implementation and presentation of MDA results is adapted from Hair et al. (2006) and is greatly inspired by Altman (1968, 1984), among other published papers of Altman.

Payment method (PMT) is not selected by the reduced stepwise logistic regressions, but it was selected by the stepwise regressions with continuous measures TQ, EVTA, EVSL. In a non-tabulated test, we found that the difference between average abnormal return of a portfolio of M&As paid with stock (PMT = 1) and average abnormal return of a portfolio of M&As paid with cash (PMT = 0) is statistically significant. The same argument applies to TGTEX. In fact, we re-examined all variables to formulate the model in E8.

TGTEX is the excess value of the target based on total assets multiplier. Previous tests in this paper have shown that TGTEX computed based on asset multiplier generates statistically more significant results than TGTEX with sales multiplier.

Specifically, since the structure matrix is unaffected by collinearity and since the ordering in structure matrix is not fundamentally different from the ordering of standard canonical coefficients, it's safe to say that collinearity has not inflated the importance of predictors in the standard coefficients table.

The coefficients in Panel B may not be readily comparable because the measurement units of the ratios are not homogenous.

Consistent with extant literature, the success of an M&A event is significantly associated with certain attributes of the deal, such as access to capital, size, and payment method. Access to capital prior to the merger event increases the likelihood of observing a successful M&A (as in Servaes 1996). The positive coefficient on SIZE variable in Z1 and Z2 models indicates that more successful M&As are made by larger acquirers, but the negative sign in Z3 and Z4 models does not support that view. M&As are more likely to be successful when the deal is paid out for by cash, which is consistent with the findings of Moeller et al. (2004). In our sample, public status of the target (investigated by Chang 1998; Fuller et al. 2002) and ratio of target equity to the acquirer’s equity (investigated by Asquith et al. 1983) are not determinants of M&A success.

The CAR [−1, +1] and CAR [−2, +2] results are generally comparable and are available upon request from the authors.

Bettis and Mahajan (1985) investigate the risk-return tradeoff in profits for 80 related and unrelated events and find that related ones outperform the unrelated. Wernerfelt and Montgomery (1988) use Tobin’s Q as a measure of performance and find that narrowly diversified firms do better than widely diversified ones. Berger and Ofek (1995) compare the sum of imputed stand-alone values to the firm's actual value and find that value loss is smaller when the segments of the diversified firm are in the same two-digit SIC code. Nevertheless, our finding does not support the organizational competencies hypothesis of Matsusaka (2001), where firms diversify when sales decline in their own industry. Instead of going out of business, they step into a new industry that “matches” their competencies and, therefore, successful diversifiers quit their original industry and transition into the new industry.

Empirically, Maloney et al. (1993) shows that the acquirer’s leverage position is positively related to the deal announcement return. They also show that stock price performance of the acquiring firm is positively influenced by leverage-increasing restructuring. The signs of the leverage ratio in our models point in the other direction.

Following Berger and Ofek (1995), we also calculate excess value based on EBIT multiplier. We obtained a much smaller sample due to lack of data and elimination of negative segment imputed value.

We show mathematical notation using total assets (TA) multiplier only. Imputed value with sales (SL) multiplier is computed in an analogous manner.

In robustness testing, we calculate cumulative abnormal return using the 2-year (+30, +720) and 1-year (+30, +360) post-event window. In the former case, the findings (not tabulated) became slightly weaker but the key implications are not significantly affected. With 1 year horizon, statistical significance of the findings is largely compromised.

In a robustness check, we used the value of TQ, EVTA, and EVSL at the end of the third year. Results are not fundamentally different but are statistically weaker.

We also computed $R_{m,16}$ as,

$$R_{m,16}=\left(\sum_{Q=-20}^{Q=-5} R_{m,Q}\right){/}16$$

Results are not fundamentally different from those obtained with $R_{m,20}.$

If the board of directors and institutional shareholders of the acquiring firm question the deal, managers might attempt to assuage pressure by delivering strong performance, creating incentives for misreporting.

They surveyed CFOs about the primary motives behind corporate M&A strategies and found that “synergy” (in the form of operating economies of scope and scale, financial economies, and increased market power) and “diversity” seem to be top motives.

The idea is that a firm that pays dividend is not likely to be capital-constrained. This approach was originally used by Fezzari et al. (1988) and also adopted by Servaes (1996). ATC is constructed as follows,

$ATC = 1 \;{\text{when}}\;DVT > 0 ;\;ATC = 0 ;\;{\text{when}}\;DVT = 0.$

Information regarding payment type, target public status, and nature of the deal were collected from 8-Ks or 10-Ks in SEC electronic files or Lexis and Nexis.

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Title: Value creation and the probability of success in merger and acquisition transactions
Authors: Yasser Alhenawi
Martha Stilwell
Publication date: 10-02-2017
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 4/2017
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-017-0616-2

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