Many researchers have studied the effects of takeovers on the value of both the target and bidder firms. The evidence indicates that the stockholders of target firms are the clear winners in takeovers –– they earn significant excess returns[1] not only around the announcement of the acquisitions, but also in the weeks leading up to it. Jensen and Ruback (1983) reviewed 13 studies that look at returns around takeover announcements and reported an average excess return of 30% to target stockholders in successful tender offers and 20% to target stockholders in successful mergers.
Jarrell, Brickley, and Netter (1988) reviewed the results of 663 tender offers made between 1962 and 1985 and noted that premiums averaged 19% in the 1960s, 35% in the 1970s and 30% between 1980 and 1985. Many of the studies report an increase in the stock price of the target firm prior to the takeover announcement, suggesting either a very perceptive financial market or leaked information about prospective deals.
Some attempts at takeovers fail, either because the bidding firm withdraws the offer or because the target firm fights it off. Bradley, Desai,and Kim(1983) analyzed the effects of takeover failures on target firm stockholders and found that, while the initial reaction to the announcement of the failure is negative, albeit statistically insignificant, a substantial number of target firms are taken over within 60 days of the first takeover is failing, earning significant excess returns (50% to 66%).
The effect of takeover announcements on bidder firm stock prices is not as clear cut. Jensen and Ruback report excess returns of 4% for bidding firm stockholders around tender offers and no excess returns around mergers. Jarrell, Brickley and Netter, in their examination of tender offers from 1962 to 1985, note a decline in excess returns to bidding firm stockholders from 4.4% in the 1960s to 2% in the 1970s to -1% in the 1980s.
Other studies indicate that approximately half of all bidding firms earn negative excess returns around the announcement of takeovers, suggesting that shareholders are skeptical about the perceived value of the takeover in a significant number of cases. When an attempt at a takeover fails, Bradley, Desai and Kim (1983) report negative excess returns of 5% to bidding firm stockholders around the announcement of the failure. When the existence of a rival bidder in figured in, the studies indicate significant negative excess returns (of approximately 8%) for bidder firm stockholders who lose out to a rival bidder within 180 trading days of the announcement, and no excess returns when no rival bidder exists.
--> CT 26.2: The managers of bidding firms whose stock prices go down on acquisitions, often argue that this occurs because stockholders do not have as much information as they do about the target firm’s finances and its fit with the bidding firm. How would you respond to the argument?
Steps in an Acquisition
There are four basic and not necessarily sequential steps, in acquiring a target firm. The first is the development of a rationale and a strategy for doing acquisitions, and what and understanding of this strategy requires in terms of resources. The second is the choice of a target for the acquisition and the valuation of the target firm, with premiums for the value of control and any synergy. The third is the determination of how much to pay on the acquisition, how best to raise funds to do it, and whether to use stock or cash. This decision has significant implications for the choice of accounting treatment for the acquisition. The final step in the acquisition, and perhaps the most challenging one, is to make the acquisition work after the deal is complete.
Developing an Acquisition Strategy
Not all firms that make acquisitions have acquisition strategies, and not all firms that have acquisition strategies stick with them. In this section, we consider a number of different motives for acquisitions and suggest that a coherent acquisition strategy has to be based on one or another of these motives.
Acquire undervalued firms
Firms that are undervalued by financial markets can be targeted for acquisition by those who recognize this mispricing. The acquirer can then gain the difference between the value and the purchase price as surplus. For this strategy to work, however, three basic components need to come together:
1. A capacity to find firms that trade at less than their true value: This capacity would require either access to better information than is available to other investors in the market, or a better analytical tools than those used by other market participants.
2. Access to the funds that will be needed to complete the acquisition: Knowing a firm is undervalued does not necessarily imply having capital easily available to carry out the acquisition. Access to capital depends upon the size of the acquirer – large firms will have more access to capital markets and internal funds than smaller firms or individuals – and upon the acquirer’s track record – a history of success at identifying and acquiring under valued firms will make subsequent acquisitions easier.
3. Skill in execution: If the acquirer, in the process of the acquisition, drives the stock price up to and beyond the estimated value, there will be no value gain from the acquisition. To illustrate, assume that the estimated value for a firm is $ 100 million, and that the current market price is $ 75 million. In acquiring this firm, the acquirer will have to pay a premium. If that premium exceeds 33% of the market price, the price exceeds the estimated value, and the acquisition will not create any value for the acquirer.
While the strategy of buying under valued firms has a great deal of intuitive appeal, it is daunting, especially when acquiring publicly traded firms in reasonably efficient markets, where the premiums paid on market prices can very quickly eliminate the valuation surplus. The odds are better in less efficient markets or when acquiring private businesses.
Diversify to reduce risk
We made a strong argument in chapter 6 that diversification reduces an investor’s exposure to firm-specific risk. In fact, the risk and return models that we have used in this book have been built on the presumption that the firm-specific risk will be diversified away and hence will not be rewarded. By buying firms in other businesses and diversifying, acquiring firms’ managers believe, they can reduce earnings volatility and risk, and increase potential value. Although diversification has benefits, it is an open question whether it can be accomplished more efficiently by investors diversifying across traded stocks, or by firms, diversifying by acquiring other firms.
If we compare the transactions costs associated with investor diversification with the costs and the premiums paid by firms doing the same, investors in most publicly traded firms can diversify far more cheaply than firms can. There are two exceptions to this view. The first is in the case of a private firm, where the owner may have all or most of his or her wealth invested in the firm. Here, the argument for diversification becomes stronger, since the owner alone is exposed to all risk.
This risk exposure may explain why many family-owned businesses in Asia, for instance, diversified into multiple businesses and became conglomerates. The second, albeit weaker case, is the closely held firm, whose incumbent managers may have the bulk of their wealth invested in the firm. By diversifying through acquisitions, they reduce their exposure to total risk, though other investors (who presumably are more diversified) may not share their enthusiasm.
1 Excess returns represent returns over and above the returns you would have expected an investment to make, after adjusting for risk and market performance.
Prof. Aswath Damodaran
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Summary: Index