Abnormal Returns From International Acquisitions

Abnormal Returns from International Acquisitions

A Survey of Related Research
Craig R. Everett - December 2007

Introduction

One of the primary results of capital structure theory [Fama and Miller (1972)] is that when taking a firm’s set of operating/investment decisions as given, the value of the firm for that period should not be affected by financing decisions. The decision to be acquired is effectively a financing decision that affects a change in the identities of the shareholders, and possibly the debt/equity balance of the capital structure. Assuming efficient markets, this should have no effect on the value of the target, and since efficient markets enforce fair prices, there should also be no impact on the firm value of the bidder. Empirically, however, this view of the world is not supported by the evidence. Jensen and Ruback (1983) summarize the results of the acquisition research (up to that point in time) and find that there is a consensus that there is a net gain in firm value overall, with gains to target firm shareholders being positive, but the impact to bidder shareholders being less certain. With international acquisitions, there are many additional complexities which may affect firm value. Moeller and Schlingemann (2005), for example, find that announcement stock returns are 1% lower for cross-border deals than for domestic deals.

This paper is intended as a brief survey of the literature related to returns from international acquisitions, though it is by no means comprehensive. As such, there are many related works that are not addressed here, and for that I extend my apologies in advance to the associated authors. The paper is organized according to the various types of effects and firm characteristics that may have an impact on acquisition returns. Sections I through IX address respectively: bidder firm characteristics, target firm characteristics, country characteristics, synergy effects, majority control effects, method of payment effects, diversification effects, information effects, and trends. Section X concludes.

I. Bidder Firm Characteristics

Characteristics of the bidding firm may have an impact on returns from international acquisitions. These characteristics include, but are not limited to, factors such as size, industry, diversification and ownership structure.

Measurement of abnormal returns based on size of bidder is problematic due to the fact that as the size of the bidder increases as compared to the size of the target, the impact of the acquisition on the bidder’s stock returns becomes increasingly difficult to distinguish from error noise due to attenuation bias [Eckbo and Thorburn (2000)]. When looking at industry factors, Chari, Ouimet and Tesar (2004) find that acquirer returns increase by a factor of 3% when they are part of an R&D intensive industry. This effect is only manifest, however, when the acquirer gains majority control of the target. Bris and Cabolis (2002), on the other hand, look at value created within the acquirer’s industry, as measured by the industry’s median firm-level Tobin’s Q. They use the median in order to prevent firms with negative Q from skewing the results. They found that neither importation of better accounting standards, nor improving quality of creditor protection, created any additional industry value. Firms with low foreign institutional ownership significantly underperformed (by 10.16%), indicating that foreign institutional ownership (and also insider ownership) are positively correlated with performance [Khanna and Palepu (1999)].

Denis, Denis and Yost (2002), when considering at the effects of industrial and global diversification on firm value (which is negative in both cases), find other firm characteristics that significantly impact firm value. Positive effects result from relative firm size, EBIT, advertising, R&D and capital expenditures, whereas the ratio of long-term debt to assets exhibits a negative effect.

Moeller, Schlingemann and Stulz (2005) find that the high-loss US acquirers during the merger wave of the late 1990’s tended to have significantly higher Tobin’s Q measurements than other acquiring firms during the same period. This effect may also be observable for international merger waves, and is therefore an area for future research.

II. Target Firm Characteristics

Several researchers have studied acquisition returns for listed versus unlisted targets. Faccio, McConnell and Stolin (2006) looked at announcement period abnormal returns for acquirers of European listed and unlisted targets and found that acquirers of listed targets receive an average abnormal return of –0.38% (yet insignificant). Unlisted targets, on the other hand, earned a significant average abnormal return of 1.48% during the same period. This effect was persistent even when controlling for method of payment, size, profitability and country. Similarly, Moeller and Schlingemann (2005) also found that bidder returns were higher for acquisitions of subsidiaries and private targets (i.e. unlisted).

The ownership profile of the target firm is considered a characteristic worthy of consideration. There is an increasing body of research surrounding “business groups”. A business group is a closely held group of companies that, traditionally, is controlled by a single extended family. These are prevalent in many parts of the world. Khanna and Palepu (1999) looked specifically at the impact of business group membership on company performance in the context of acquisitions by institutional investors. They found that firm performance is highly correlated with the type of the investor (whether it is a domestic institution vs. international) but business group membership was not significant. Business group firms with foreign ownership performed well. One possible interpretation of this effect is that foreign institutions tended to only pick firms from business groups that were sufficiently transparent to allow effective monitoring. Target membership in a family business group appears to reduce the likelihood of foreign investment. Looking at data from Indian companies they find that, in general, foreign institutional investors are the best monitors, whereas domestic (Indian) institutional investors are the worst monitors. Transparency is also a key factor. They use the level of intra-group financial transactions as a proxy for transparency. The fewer the transactions, the more transparent the group is. They find that the more transparent the group, the more foreign investment the group receives. And since foreign investment leads to better monitoring, it follows that transparency will lead to better firm performance.

La Porta et al. (1998) point out that high ownership concentration may also be a symptom of poor investor protection in the target country. They examined the largest public companies internationally and found a significant result that the countries with the weakest investor protection laws also had the highest concentration of ownership. Of course, high ownership concentration in such places may be a good thing, since it could lead to more effective monitoring practices by these large blockholders (since they have such a meaningful stake in the business), and this more vigilant monitoring should increase the overall value of the firm [Schleifer and Vishny (1986)].

Differences in the nature and quality of corporate governance between the bidder and target may also account for differences in acquisition returns. Rossi and Volpin (2001) correctly point out that in most cases the governance quality of the acquiring firms in cross-border deals is higher than for the target firms. This of course could be an effect of self-selection, since normally it is successful firms that do acquisitions, and success could certainly be related to governance factors. Rossi and Volpin (2004) focus on all hostile bids for cross-border targets, regardless of whether or not the deal was completed. Their theory is that even a failed hostile bid will succeed in disciplining the management of the target company and improving governance. It serves as a wake-up call. Their results show that the number of hostile takeover bids is highly positively correlated with English legal origin, accounting standards and shareholder protection.

III. Country Characteristics

There is an increasing body of research regarding country characteristics and how they relate to financial markets and acquisition returns. Most scholars seem to agree that healthy financial activity in a country is positively related with investor protections and freedom. Specifically, bidder returns are positively correlated with amount of takeover activity in target country and with a shareholder friendly legal system [Moeller and Schlingemann (2005)].

La Porta et al (1997) look at the ability of firms in various countries to raise external financing (either equity or debt). The relevance of this characteristic to international acquisitions is that a target firm in a country with poor access to capital may have a significant incentive to accept an acquisition offer from a bidder with better access to capital (or better sources of internal financing). They find that countries with common law legal origins have the best access to equity markets, whereas French legal origin countries have the worst. With regard to debt, common law still provides better access than French origins, however the best legal origin for debt is German. LLSV attribute the substandard development of capital markets in French origin countries to the relative lack of investor protection. So although firms in French origin countries may have the greatest capital market incentives to seek a common law origin buyer, the common law bidder may be wary of purchasing a target in a country with inferior investor protections. Of course, implementing any investor protection reforms is easier said than done. La Porta et al. (2000) point out that such reforms are energetically resisted by both governments and business groups, who both see these changes as a relinquishment of power.

This attitude towards reform is self-defeating, though, since it has been shown that there is a significant positive correlation between investor protection and firm value. In their paper on corporate valuation, La Porta et al. (2002) take the largest 20 firms that have a large blockholder (more than 10% ownership) in each of 27 countries. They regress tobin’s Q against investor protection proxies (legal origin, anti-director rights and cash-flow rights) and find that poor investor protection does indeed negatively impact valuation.

Eckbo and Thorburn (2000) hypothesize that the target firm country’s government regulation of foreign takeovers may explain the significant underperformance of US bidder firms acquiring Canadian targets between 1974 and 1984. They studied Toronto Stock Exchange (TSE) listed targets being acquired by other TSE listed Canadian companies as well NYSE listed US companies between 1964 and 1984. They found that stock returns for Canadian bidders significantly outperformed acquisitions by similar US bidders. This effect was especially pronounced after 1973 when Canada implemented the Foreign Investment Review (FIR) Act, which required foreign bidders to register and disclose a great deal of information regarding ownership structure and future plans regarding the target. Their hypothesis is that compliance with FIR may have had the effect of transferring a significant portion (or all) of the expected economic rents from the acquisition to the target shareholders, or possibly even to the domestic competitors in the bidding.

Starks and Wei (2004) study the differences in corporate governance norms for the bidder and target countries in cross-border deals with a stock method of payment. They find that when the governance of the bidder is inferior to that of the target, the bidder must pay a higher takeover premium to compensate. In a similar line of reasoning, they confirm that abnormal bidder returns are higher when the bidder home-country governance is superior to that of the target. These relationships disappear, however, when they aggregate bidder and target returns together.

Chari, Ouimet and Tesar (2004) look specifically at acquisition targets in emerging markets and conclude that there are clearly abnormal and significant acquirer gains (1.79 to 2.28%) when a US company announces an emerging market acquisition. Because this acquirer gain is combined with the well-documented target gains in these announcements, the net effect is a statistically significant increase in overall shareholder wealth. When the deal results in majority control of the target firm, the acquirer gains jump to between 5.8 and 12.9% depending on the specification, which are all significant at the 1% level.

In their 2005 version of the paper, Chari, Ouimet and Tesar also look at the “institutional quality” of the target country. This measure includes factors such as legal system and political risk. Rather than just adding this measure as a control variable to the regression, they calculate a “distance” measure of institutional quality, which is the institutional quality measure of the acquirer country minus the institutional quality of the target country. They found no significant relationship between this control variable and abnormal returns.

Bris and Cabolis (2002) extend the work of La Porta et al. and find that the origin of the legal system of both countries involved in a cross-border acquisition has a significant impact upon stock returns. They control for a variety of factors, including accounting standards, creditor protection, stockholder protection, corruption and governance quality, and find that the most profitable mergers (for both acquirer and target) are deals between bidders of English legal origin and targets of Nordic legal origin. The most dramatic drop in value happens when companies in countries of French legal origin acquire English origin companies. They site the purchase of Seagram (Canadian) by Vivendi as a prime example. In the vast majority of cross-border deals, there is a disparity between shareholder protection provided by the respective countries. In fact, they find that only 15% of the deals occur where the levels of shareholder protection are the same for both target and acquiring countries. They also point out a potential area of weakness with the SDC data on mergers. They indicate that SDC has a very limited number of mergers for countries without merger laws. Either the mergers are just not occurring in those countries (hence no need for laws) or possibly the mergers are happening, but the lack of disclosure laws means that the deals occur invisibly.

Interestingly, Bris and Cabolis (2002) find the perverse result that when an acquirer from a less corrupt country gains control of a firm from a more corrupt country, the target firm loses value. The somewhat cynical theory for this phenomenon is that the importation of a more strict governance model hinders the target’s ability to operate efficiently within the corrupt local marketplace. They can no longer “play the game” as it is normally played, so they are put at a competitive disadvantage in their market. Another theory is that the acquiring firms may fully exploit the target’s relationships to extract maximum benefit to the acquirer.

Taking a different approach, Rossi and Volpin (2004) find that, when looking at all deals domestic and cross-border, the probability of a complete deal being cross-border is much higher when the target country has lower investor protection. On the other hand, higher levels of investor protection are associated with increased levels of M&A activity and more attempted hostile takeovers.

IV. Synergy Effects

When management is trying to sell the idea of a merger to the shareholders, they typically extol the tremendous synergies that will be gleaned from the marriage of the two companies. The claim is made that these synergies will increase efficiency, reduce costs, and take the improved company to new heights. Many scholars have studied these synergies and have reported mixed results.

Eckbo and Thorburn (2000) consider the possibility that domestic acquisitions create more synergy than cross-border mergers because the resulting merger could take advantage of horizontal efficiencies within the same marketplace. They test this theory by segmenting their data by industry code, in order to determine if the abnormal returns of domestic acquisitions are exaggerated when the bidder and target belong to the same industry code. They found no significant indication of domestic horizontal synergy effects.

On the other hand, Chari, Ouimet and Tesar (2004) find significant shareholder wealth created in cross-border acquisitions of emerging market firms. They suggest several possible synergies that could be driving this phenomenon. One of these synergies is increased access to capital. In emerging markets the costs of capital can be quite high, so becoming part of a MNC can provide access to internal company capital which may allow the target to pursue positive NPV projects that would otherwise be prohibitively difficult to fund. They also suggest that synergies may be created that allow less expensive access to the target local markets. Along this same idea of increased local market access, Antras, Desai and Foley (2007) show that acquisition is frequently the most efficient method of deploying technology abroad, especially considering the complexities of licensing and monitoring foreign companies.

V. Majority Control Effects

Chari, Ouimet and Tesar (2004) show a significant relationship between positive gains from emerging market acquisitions and whether the acquirer gains majority control of the target. This is especially important in countries where minority shareholder rights are poorly protected. Their theory is that by obtaining majority control, the acquirer is better able to transfer technologies and capital to the target, as well as engage in more effective monitoring of local management. In their study, the MAJORITYCONTROL coefficient was significant at the 1% level and ranged between a minimum of 5.8% and a maximum of 7.8%, depending on the presence of various other control variables.

VI. Method of Payment Effects

It has been observed in several papers that acquisition returns are impacted by the method of payment. The three methods available to a bidder are cash, stock, or a mixture of the two. The observed effects typically appear in both domestic and international deals.

Rau and Vermaelen (1998) were not specifically looking at international acquisitions, but found a statistically significant relationship between long term bidder returns and whether the deal was a merger or a tender-offer. Tender-offers exhibited significant positive abnormal returns, whereas mergers were consistently negative (and sometimes significant). This was generally the case across the three types of bidder firms they studied (value, glamour, and neutral). When looking specifically at method of payment (cash or stock), they found that glamour firms performed worse in every case for either payment method.

Eckbo and Thorburn (2000) argue that, although there seems to be a consensus in the literature that superior performance of all-cash offers is due to tax considerations, this does not account for all of the abnormal returns. They offer alternative explanations, like signaling effects, but in the end their data actually shows that the payment method with the highest abnormal returns is neither all-cash nor all-stock, but rather a payment of mixed cash and stock.

The acquisition premium paid by inferior governance bidders, explored by Starks and Wei (2004), is only significant when the method of payment is stock. They find that when the governance of the bidder is inferior to that of the target, the bidder must pay a higher takeover premium to compensate. Bidders also pay a premium for publicly listed targets. This listing effect remains after controlling for the method of payment for the target [Faccio, McConnell and Stolin (2006)].

Exploring the link between method of payment and legal environment, Rossi and Volpin (2004) find that cash payment is negatively (and highly) correlated with shareholder protection. Specifically, a one-point increase in the level of shareholder protection results in a reduction of the probability of using all cash by an average of 15.5%.

VII. Diversification Effects

Agmon and Lessard (1977) showed that US investors reward companies that diversify internationally. Their explanation for this behavior is that there are barriers (mostly information asymmetries and other market inefficiencies) that make it preferable for individuals to invest in companies with international operations, rather than to directly invest internationally themselves. This is mainly the result in significant differences in the market-assigned risk between domestic companies and MNCs. Brewer (1981) takes issue with this conclusion, arguing that both risk and return must be considered together. The results of his study indicate that there is no significant difference between the risk-adjusted returns for domestic companies and MNCs, which would suggest that international diversification by a domestic firm provides no additional value to investors that cannot be obtained privately in the investors’ own portfolios. Adler (1981) also dismisses the Agmon and Lessard (1977) results, but on the basis that capital market imperfections cannot possibly explain international diversification by MNCs any more than horizontal diversification by domestic companies can be explained by domestic market inefficiencies.

Denis, Denis and Yost (2002) look at the interaction of industrial diversification and global diversification with respect to their effect on firm value. Previous studies had shown that, individually, each form of diversification has a negative impact on firm value. Between 1984 and 1997, the summary statistics show that there was a decrease in the overall level of industrial diversification, while the level of global diversification increased during the same period. This is consistent with the fact that industrial diversification fell out of favor in the management literature during that period, while the benefits of global diversification were beginning to be widely extolled. It turns out, though, that global diversification is just as bad an idea with regard to firm value. Denis et al. use excess value as the dependent variable in their regressions, defined as the percentage difference between the total of MV of equity plus BV of assets minus BV of common equity and the sum of imputed stand-alone values of each industrial segment of domestic firms. The results of their multivariate analysis show that the valuation discounts for industrial and global diversification are 20% and 18%, respectively. Moreover, the discount for firms that are diversified in both ways is 32%. Their paper also demonstrates that the discount becomes more pronounced as the level of global diversification of the firm (measured by the percentage of sales from foreign operations) becomes larger. Moeller and Schlingemann (2005) also confirm that returns are negatively associated with both industrial and geographical diversification.

VIII. Information Effects

A few studies have been done that look at information effects and how they relate to acquisition returns. In emerging markets, stock prices are often considered to be unreliable estimates of the actual value of the company. This creates a potential information asymmetry, where the foreign acquirer may have a better idea of the target firm’s true value, specifically as it relates to potential synergies with the acquirer [Chari, Ouimet and Tesar (2004)]. The acquirer can take advantage of this asymmetry by only selecting deals where it can generate abnormal positive gains.

In a totally different line of research, Faccio, McConnell and Stolin (2006), observe a significant listing effect for international acquisitions. Bidders must pay a premium for listed targets vs. unlisted. They find that this effect remains significant even after controlling for the pre-announcement leakage of information about the deal.

IX. Trends

There have been a couple of significant trends identified with respect to international acquisitions. The few that have been documented, however, are very interesting. Moeller and Schlingemann (2005) documented the trend that bidder gains from cross-border deals are increasing over time as more cross-border deals are done. On the subject of governance, Rossi and Volpin (2004) believe that the tendency for high quality governance countries to acquire targets in lower quality governance countries will ultimately have the effect of promoting global convergence of governance standards.

X. Conclusion

The body of research regarding mergers and acquisitions is tremendously large and growing. Historically, most research on this subject has been done using US companies and data. As more and more companies expand and diversify globally, the incidence of international acquisitions is rapidly increasing. This has become a topic of heightened interest in both the academic as well as business world. We observe that much of the US-based M&A research is now being extended to include international data sets.

As the research is extended internationally, we see that there are a variety of new factors and effects at play. This paper attempts to catalog a few of the most important aspects of these international deals, and what the current research says about them. By looking at the relevant results regarding bidder firm characteristics, target firm characteristics, country characteristics, synergy effects, majority control effects, method of payment effects, diversification effects, information effects, and trends, hopefully the reader will gain a general understanding of the overall current state of the practice regarding international acquisitions.

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