BUSI 536 Week 7 Individual Research Paper Example

Who Gains From Mergers? Testing the Synergy, Agency, Hubris and Misvaluation Theories

Introduction

Mergers and acquisitions are among the largest investment decisions companies make, yet the evidence on their results presents a puzzle. Shareholders of acquired companies routinely receive premiums of 20 to 50 percent over the prior market price. The combined value of the two companies usually rises only modestly when a deal is announced. And shareholders of acquiring companies often gain nothing or lose. If mergers create value, why do acquirers so seldom share in it? If they do not, why do companies keep making them?

Four theories offer answers. Synergy theory holds that mergers create value by combining resources, and that competition among bidders passes most of the gain to targets. Agency theory, especially Jensen's free cash flow argument, holds that managers acquire to enlarge the firms they control even when acquisitions destroy value. Roll's hubris hypothesis holds that bidders overpay because their managers overestimate their own judgment. Misvaluation theory holds that acquirers with overvalued stock use it as currency to buy real assets. Gaughan (2018) presents these motives as the main explanations offered for merger activity. This paper reviews the evidence on each and argues that mergers create value on average, that most of it goes to target shareholders, and that the losses acquirers suffer are concentrated in deals best explained by hubris and misvaluation.

The review concentrates on studies of acquisitions of U.S. public companies, where stock prices allow gains to be measured, and on peer-reviewed research spanning several merger waves, from the conglomerate deals of the 1960s through the stock-financed technology and telecommunications deals around 2000. Studies from different periods sometimes reach different conclusions, and part of the task is to explain why. The paper first explains how merger gains are measured, then takes each theory in turn, stating what it predicts and what the evidence shows, before comparing the theories and drawing out implications for the boards that approve acquisitions.

Measuring the Gains From Mergers

Researchers measure merger gains in three main ways, and the theories make different predictions about each. The first is the announcement return: the change in the stock prices of the bidder and target over a few days around the announcement, adjusted for market movements. Because prices respond quickly to new information, the announcement return estimates the market's judgment of the deal's value. The second is the long-run stock return in the years after the deal, which reveals whether the market's initial judgment was right. The third is operating performance, usually measured as cash flow relative to assets, which shows whether the combined business actually performs better.

Each measure has limits. Announcement returns can mix the value of the deal with information the announcement reveals about the bidder, for example that its managers believe its stock is overvalued. Long-run returns are sensitive to the benchmark used. Operating performance requires a comparison group of similar firms that did not merge. A careful reading of the evidence considers all three.

Synergy Theory

Synergy theory holds that the combined firm is worth more than the two firms separately, through cost savings, revenue growth, better use of assets or more efficient management. If this is the main reason for mergers, the combined value of the two firms should rise when a deal is announced, and operating performance should improve afterward. The theory does not predict that acquirers will gain, because when several potential buyers can produce similar synergies, competition bids the price up until the target's shareholders capture most of the value.

The evidence on combined gains supports synergy theory. Bradley et al. (1988) studied successful tender offers from 1963 to 1984 and found that the combined value of target and acquirer rose by roughly 7 percent on average. Target shareholders captured most of the gain, and their share rose over time as competition for targets intensified. Andrade et al. (2001), studying mergers from 1973 to 1998, found that target shareholders earned about 16 percent around announcement while acquirers earned slightly negative returns, and that the combined response was positive, at about 2 percent. They also found that merger activity clustered by industry, with deregulation accounting for nearly half of merger activity from the late 1980s through the 1990s, which suggests that many mergers are responses to real economic shocks rather than managerial whims.

Operating evidence points the same way. Healy et al. (1992) examined the 50 largest mergers between U.S. public industrial firms from 1979 to 1984 and found that the merged firms' operating cash flow returns improved relative to their industries, mainly because they used their assets more productively, not because they cut long-term investment. The announcement returns for these deals were correlated with the later improvements, suggesting that the market's initial judgments were reasonably accurate. Andrade et al. (2001) likewise reported improved operating performance after mergers relative to industry peers.

The synergy evidence explains why mergers happen and why targets gain; it does not explain why acquirers so often lose.

Synergy theory also leaves a practical question open: which synergies are real? Gaughan (2018) distinguishes operating synergies, such as economies of scale, combined distribution and shared technology, from financial synergies, such as a lower cost of capital for a larger, more diversified firm. Cost synergies are generally easier to estimate and to achieve, because they depend on decisions the acquirer controls, such as closing duplicate facilities. Revenue synergies depend on customers' behavior and are more often overestimated. Financial synergies from diversification are the weakest, since shareholders can diversify their own portfolios at little cost. A deal justified mainly by revenue or diversification synergies therefore rests on the parts of synergy theory with the least empirical support, which helps explain why such deals feature prominently among the failures discussed below.

Agency and Free Cash Flow Theory

Jensen (1986) argued that managers of firms generating cash beyond what profitable investment opportunities require face a conflict with shareholders. Paying the cash out shrinks the resources managers control, while spending it on acquisitions enlarges their firms, their prestige and often their pay. Jensen used the oil industry of the early 1980s as his example: companies with large cash flows and declining investment opportunities spent heavily on exploration and on acquisitions outside the industry, some of which destroyed value. Debt, in his account, disciplines managers by committing them to pay out cash, and takeovers punish managers who waste it.

The agency theory predicts that acquirers with large free cash flow and weak governance should earn lower returns on their acquisitions, and that diversifying acquisitions, which offer managers size without synergy, should perform worse than related ones. Gaughan (2018) notes that the conglomerate merger wave of the 1960s was followed by widespread divestitures in the 1970s and 1980s as many diversified firms were broken up, a pattern consistent with acquisitions that served managers more than owners. Two studies tested these predictions directly. Morck et al. (1990) examined 326 U.S. acquisitions from 1975 to 1987 and found that bidding shareholders earned systematically lower, and mostly negative, announcement returns in three kinds of deals: when the bidder diversified into an unrelated business, when it bought a rapidly growing target and when its own managers had performed poorly before the acquisition. Each pattern fits a managerial motive, whether the wish to reduce the risk to managers' own positions through diversification, the appeal of buying growth the firm could not produce itself or an attempt by struggling managers to change the subject. Lang et al. (1991) tested Jensen's hypothesis more specifically, separating bidders with poor investment opportunities, measured by a low ratio of market value to replacement cost, from those with good ones. Among bidders with poor opportunities, returns were significantly lower the more cash flow the bidder had, exactly as the free cash flow theory predicts; among bidders with good opportunities, cash flow did not hurt.

Agency theory therefore explains some acquirer losses, particularly by cash-rich firms in mature industries, but it does not explain why acquirers with strong governance also overpay, or why losses are concentrated in particular periods.

The Hubris Hypothesis

Roll (1986) proposed a more provocative explanation. Suppose bidders are rational in every respect except that their managers overestimate their own ability to judge a target's value. Each bidder estimates the target's value with some error, and the bidder whose estimate is highest wins. The winner is therefore likely to be the bidder that overestimated the most, an outcome known as the winner's curse. If hubris were the only motive, the theory predicts, mergers would create no value on average; the premium paid to target shareholders would simply be transferred from bidder shareholders, and combined returns would be close to zero.

The combined gains found by Bradley et al. (1988) and Andrade et al. (2001) show that hubris cannot be the whole story, since mergers on average create some value. But the hubris hypothesis explains a pattern synergy theory leaves unexplained: why bidders keep paying premiums that leave their own shareholders no better off. Later research supports Roll's mechanism. Malmendier and Tate (2008) used a revealing behavioral measure, chief executives who held deep-in-the-money options on their own company's stock until close to expiration instead of exercising them and diversifying, and found that these executives were considerably more likely to make acquisitions, especially diversifying ones; investors, for their part, greeted the deals they announced with sharper price declines. The effect was strongest when the companies had abundant internal cash and did not need to persuade outside investors to finance the deal, which links hubris to Jensen's free cash flow argument: overconfident managers with cash to spend are the most likely to overpay. The hubris hypothesis is best understood as an explanation of how gains are divided and of why some deals destroy value, rather than as a complete theory of mergers.

Misvaluation Theory

Shleifer and Vishny (2003) offered a theory based on stock market misvaluation. Suppose managers know when their stock is overvalued. Acquiring another firm with that stock converts an overvalued currency into real assets, which benefits the acquirer's long-term shareholders even if the acquisition creates no synergy and the target is itself somewhat overvalued. The theory predicts that merger waves will coincide with high stock market valuations, that stock-financed acquisitions will be common in those waves, and that acquirers paying with stock will earn poor long-run returns as overvaluation corrects, even though their shareholders are better off than they would have been without the deal.

The evidence fits several of these predictions. Rhodes-Kropf et al. (2005) decomposed firms' market-to-book ratios into components reflecting fundamental value and components reflecting misvaluation and found that acquirers tended to be more overvalued than their targets, that misvaluation helped explain which firms bought and which were bought, and that merger activity rose with sector-level misvaluation. In the 1998 to 2001 wave, Moeller et al. (2005) calculated, acquirers' shareholders gave up 12 cents for every dollar their companies spent on acquisitions, for a total of $240 billion, compared with 1.6 cents per dollar in the 1980s. The losses were concentrated in a small number of large deals by acquirers with extremely high valuations, and without those deals acquirers' wealth would have increased. The misvaluation theory, together with hubris, best explains these concentrated losses.

The method of payment connects the theory to evidence that predates it. Andrade et al. (2001) observed that mergers in the 1990s were mostly stock swaps, in contrast to the cash tender offers of the 1980s, and that announcement returns for acquirers were worse in stock-financed deals than in deals paid for in cash. A bidder that offers stock signals, intentionally or not, that its managers consider the stock a good currency to spend, and the market adjusts the bidder's price accordingly. Shleifer and Vishny's (2003) model turns this signal into a strategy: when the stock truly is overvalued, paying with it can be the best choice for long-term shareholders even though the announcement return is negative. The theory therefore implies that a negative announcement return in a stock deal is not always evidence of a bad decision, a subtlety that makes stock-financed mergers harder to judge than cash deals.

Weighing the Theories

The theories are not mutually exclusive, and the evidence suggests that each explains part of merger activity. Synergy explains why the average merger creates value and why mergers cluster in industries facing real shocks. Competition among bidders explains why targets capture most of that value. Agency problems and hubris explain why some acquirers pay more than any synergy could justify. Misvaluation explains why losses concentrate in periods of high valuations and in stock-financed deals. The theories also differ in what they imply for policy. If synergy dominates, rules that make takeovers harder, such as the defenses discussed earlier in the course, harm shareholders by blocking value-creating combinations. If agency problems dominate, stronger boards and more active shareholders are the remedy. If hubris and misvaluation dominate, the remedy lies in the acquirer's own decision process: independent valuations, limits on stock-financed deals during periods of high valuation and directors willing to say no to a confident chief executive. Because all four forces appear in the evidence, sound governance needs all three remedies.

A single deal can reflect several motives at once: a chief executive may genuinely believe in a strategic combination, overestimate the synergies and find the decision easier because the company's stock seems expensive.

Limitations of the Evidence

The evidence reviewed here has limits that any conclusion must respect. First, most studies measure value through stock prices, which assumes that markets assess deals correctly at announcement. If markets are themselves misvaluing firms, as misvaluation theory argues, announcement returns may measure the market's mistakes as much as the deal's merits. Second, studies of public companies leave out the large number of acquisitions of private firms and subsidiaries, which are often small, cash-financed and, by several accounts, more favorable to acquirers because there is less competition for them. Third, operating performance studies depend on the choice of comparison firms, and mergers often occur in industries undergoing change, which makes a clean comparison difficult. Fourth, averages conceal enormous variation: the same body of research that finds modest combined gains also documents deals that created and destroyed tens of billions of dollars. Finally, the theories are difficult to separate in a single deal, since managers rarely announce that they are acquiring to build an empire or to spend overvalued stock. These limits do not overturn the main findings, which are consistent across many studies and methods, but they caution against applying averages mechanically to an individual decision.

Implications for Boards and Managers

The evidence has practical implications for the boards that approve acquisitions. First, because competition passes most synergies to targets, an acquirer should pursue deals where it has a synergy that other bidders cannot match, a condition that makes overpayment less likely. Second, because hubris and misvaluation drive the largest losses, boards should be most skeptical when the acquirer's stock is highly valued, when the chief executive has a record of acquisitions, and when the deal is paid for in stock. Third, because the market's initial reaction is a reasonably good predictor of later operating results, as Healy et al. (1992) found, a sharply negative reaction to an announcement deserves serious attention rather than dismissal. Gaughan (2018) notes that many acquirers set a maximum price before negotiations begin; the research suggests that this simple discipline protects shareholders from the dynamics that produce the worst deals. Fourth, boards should pay attention to who is advising them and how those advisers are paid, since bankers and other advisers who earn fees only when a deal closes have reasons to encourage completion. Finally, boards should require a review of each acquisition two or three years after closing, comparing realized synergies with the estimates used to justify the price. Such reviews are rare, but without them a company cannot learn whether its acquisition process is producing value or simply transferring it to the shareholders of the firms it buys.

Conclusion

The research on mergers resolves the opening puzzle in a way that is consistent across decades. Mergers create value on average, largely through real economic combinations that cluster in industries facing change. Most of that value goes to target shareholders, because bidders compete for the best opportunities. Acquirers lose when they overpay, and the largest losses come from deals best explained by managerial hubris and stock market overvaluation rather than by synergy. For managers and boards, the answer is to approach acquisitions with a clear view of where value comes from, who is likely to capture it and how easily confidence can turn into overpayment.

References

Andrade, G., Mitchell, M., & Stafford, E. (2001). New evidence and perspectives on mergers. Journal of Economic Perspectives, 15(2), 103-120. https://doi.org/10.1257/jep.15.2.103

Bradley, M., Desai, A., & Kim, E. H. (1988). Synergistic gains from corporate acquisitions and their division between the stockholders of target and acquiring firms. Journal of Financial Economics, 21(1), 3-40. https://doi.org/10.1016/0304-405X(88)90030-X

Gaughan, P. A. (2018). Mergers, acquisitions, and corporate restructurings (7th ed.). Wiley.

Healy, P. M., Palepu, K. G., & Ruback, R. S. (1992). Does corporate performance improve after mergers? Journal of Financial Economics, 31(2), 135-175. https://doi.org/10.1016/0304-405X(92)90002-F

Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. The American Economic Review, 76(2), 323-329.

Lang, L. H. P., Stulz, R. M., & Walkling, R. A. (1991). A test of the free cash flow hypothesis: The case of bidder returns. Journal of Financial Economics, 29(2), 315-335. https://doi.org/10.1016/0304-405X(91)90005-5

Malmendier, U., & Tate, G. (2008). Who makes acquisitions? CEO overconfidence and the market's reaction. Journal of Financial Economics, 89(1), 20-43. https://doi.org/10.1016/j.jfineco.2007.07.002

Moeller, S. B., Schlingemann, F. P., & Stulz, R. M. (2005). Wealth destruction on a massive scale? A study of acquiring-firm returns in the recent merger wave. The Journal of Finance, 60(2), 757-782. https://doi.org/10.1111/j.1540-6261.2005.00745.x

Morck, R., Shleifer, A., & Vishny, R. W. (1990). Do managerial objectives drive bad acquisitions? The Journal of Finance, 45(1), 31-48. https://doi.org/10.1111/j.1540-6261.1990.tb05079.x

Rhodes-Kropf, M., Robinson, D. T., & Viswanathan, S. (2005). Valuation waves and merger activity: The empirical evidence. Journal of Financial Economics, 77(3), 561-603. https://doi.org/10.1016/j.jfineco.2004.06.015

Roll, R. (1986). The hubris hypothesis of corporate takeovers. The Journal of Business, 59(2), 197-216. https://doi.org/10.1086/296325

Shleifer, A., & Vishny, R. W. (2003). Stock market driven acquisitions. Journal of Financial Economics, 70(3), 295-311. https://doi.org/10.1016/S0304-405X(03)00211-3