Buy Smart, Time Smart: Are Takeovers Drivenby Growth Opportunitiesor Mispricing?
Excessively high pricing by bidders and targets can be explained by new growthopportunities created by the merger or by irrational overpricing in financial markets. Weintegrate both explanations through a new decomposition of firm value and investigate whether itis “true” growth value or mispricing that drives takeover waves. We find that “bidders buy smart.” Bidders primarily have high market values because of growth opportunities and overpricing, and selecttargets that are less overpricedwith similar fundamental growth value. Bidders also seem to “timesmart.” Takeover activity increases when bidders are more over priced, in orderto cushion against price corrections.
This article corresponds to Chapter 4 of Van Bekkum’s PhD dissertationfromTinbergen Institute, the Netherlands. The authors would like to thank the members of his dissertation committee for theircomments. The authors are especially grateful to Anjolein Schmeits and an anonymous referee for valuable comments and suggestions, andto Bill Christie (the editor).
Sjoerd Van Bekkum is an Assistant Professor at theErasmus School of Economics, Erasmus University,P.O. Box 1738, Rotterdam, 3000 DR, Netherlands.
Han Smit is a Professor at the Erasmus School of Economics, Erasmus University, P.O. Box 1738, Rotterdam, 3000 DR, Netherlands.
Enrico Pennings is aProfessor at the Erasmus School of Economics, Erasmus University, P.O. Box 1738, Rotterdam, 3000 DR, Netherlands.
I.Introduction
To justify their intended business strategies in takeover announcements to shareholders, management teams frequently argue that new synergies and growth opportunities arise from the combined entity. Yet, previous research has found conflicting evidence as to what drives merger activity. In view of the vast literature on mergers and acquisitions (M&A), explanations for M&A can be roughly classified into two classes that have both found empirical support: 1) a rational explanation and 2) a behavioral explanation.
Consistent with neo-classical rational theory, prior studies indicate that high market values of bidders and a takeover premium for targets reflect rational expectations of cost efficiencies, synergies, market power, and growth options accordingly appreciated by financial analysts and equity investors. Mergers may reallocate assets more efficiently in response to industry shocks (Mitchell and Mulherrin, 1996) and deregulation, removing “long standing barriers to merging and consolidation, which might have kept the industry artificially dispersed” (Andrade, Mitchell, and Stafford, 2001). Consolidation is found to have been the driving force behind acquisitions in the 1990s (Holmstrom and Kaplan 2001; Andrade et al, 2001). In line with the rational view, real options theory implies that acquisitions confer valuable new growth opportunities for the combined entity (Klasa and Stegemoller, 2007).
In contrast to rational theories, two distinct behavioral views offer alternative explanations for what drives merger waves (Baker, Ruback, and Wurgler, 2007). Apart from the biases of decision makers, market inefficiencies may arise when financial markets fail to price firms correctly (Shiller, 2000)[1]. High market values are strongly related to merger activity (Rhodes-Kropf and Viswanathan, 2004; Jensen, 2005) and managers of overvalued firms buy targets that are less overvalued (Rhodes-Kropf, Robinson, and Visnawanathan, 2005).
While the different explanations for M&A may be, at least in part, due to a wide range of methodologies applied (Baker et al., 2007), they may also indicate common ground. This makes intuitive sense. The scope for valuation errors or mispricing is greater when "elusive" growth options value is a major source of expected value than when value gains arise from exploiting established products and established markets. Hence, if takeovers are jointly explained by both theories, combining theories for mispricing and investment opportunities offers a stronger theoretical base for high market values in takeovers. To facilitate an integrated analysis, we devise a new measure for fundamentalgrowth options value that adjusts market-based growth options value for mispricing. Fundamental value is based on company fundamentals such as book value, net income, and leverage, while mispricing is unrelated to fundamental value creation.
We find that takeovers do confer valuable growth opportunities, but these are strongly contingent upon market sentiment. The conventional (market-based) growth options measures should be used with care, as they can be driven by overvaluation and need to be corrected for mispricing. By analyzing firm properties (e.g., involvement in a merger and the role of the target or bidder) and deal properties (e.g., form of payment, acquisition financing, and deal attitude), we find that deal properties that favor overvalued bidders are significantly related to bidder overpricing (and to their growth options value), as well as to the growth options value of targets (but not their overpricing). These results lead to two key implications.
First, “bidders buy smart.” Although bidders have highfundamental growth options value relative to non-bidders and target firms, they are overvalued by the market. This implies that their over priced equity allows them to finance their acquisitions inexpensively. Their targets are priced lower when compared to firms not involved in a merger, but have a similar growth options value that persists after controlling for mispricing. This suggests undervaluation, at least with respect to the bidder’s equity,while fundamental growth option value is retained. Second, bidders time their takeovers accordingly. Specifically, when excess pricing for bidders is high, takeover activity is high as well. Thus, acquisitions are made by firms that are overvalued relative to their peers. Additionally, growth options value for targets is negatively related to takeover activity. Therefore, when bidders are overvalued, they acquire targets that are undervalued relative to the bidder. In effect, this will cushion against an eventual correction in share price while retaining growth potential.
These results are validated using a large international dataset. By using market-implied growth options value and controlling for pricing errors, we avoid using sophisticated option models that introduce substantial model and parameter uncertainty. In a 12-year panel of over 30,000 observations, we use t-tests and multiple equation models in a multivariate settingto demonstrate that bidders buy smart. In order to confirm that bidders also time their acquisitions smart, we estimate the relation between growth opportunities, mispricing, and takeover activityin a similar empirical setting.
Our paper proceeds as follows. In Section II, we position our contribution into the literature. In Section III, we derive the hypotheses. Section IV describes the data and decomposition employed, followed by a presentation of the results in Section V. Section VIcontains our conclusion and presents implications for further research.
II. Literature Review
A. Real Options Theory in M&A
Recent real options models explain the dynamics of mergers and acquisitions decisions under uncertainty, such as the timing of takeovers under competition (Morellec and Zhdanov, 2005), the associated division of the surplus between acquirer and target, the pro-cyclical nature of waves when they are motivated by economies of scale (Lambrecht, 2004), and the timing of mergers when they are driven by diversification (Thijssen, 2008).[2] Smith and Triantis (1995) suggested that aside from flexibility and divesture options, acquisitions contain significant growth options. In addition to the value of future cash flows and synergy values, combined forces may enhance the value of the option to invest in new products and the option to acquire other competitors. Takeovers also limit competition by eliminating the target’s option to grow, and the combined entity may more effectively allocate resources between the markets of the bidder and the target. Consistent with this idea, Klasa and Stegemoller (2007) find that serial takeovers are the result of time-varying changes in the growth opportunity set of the acquirer.
For the bidder, executing an acquisition is effectively exercising an option to exchange the acquisition price (either in cash or the acquirer’s shares) for the value of the target (Margrabe, 1978). Thus, the opportunity to acquire a target’s equity can be seen as an option while, additionally, the target itself is a portfolio of real growth options. The target’s strategic growth options generate follow-on opportunities that are part of the underlying value of the option to exchange. Relative to the earnings capacity of assets in place, the value of growth options is elusive and difficult to estimate, which may influence the timing and value of the option for the bidder. Therefore, acquisitions become more attractive when the bidder’s equity is overvalued and the acquisition can be paid for or financed with equity, or when the fundamental growth option value of the target is high and the target is less overvalued or even undervalued. In terms of fundamental value, the real exchange option is more in the money when the bidder is overvalued relative to its target. This, however, is not necessarily observed in financial markets.
B. Empirical Real Options Analysis
Miller and Modigliani (1961) determined that a firm’s equity value (P) can be partitioned into the value of a firm’s assets in place (VAIP) and the present value of future investments in growth opportunities (VGO):
P = VGO + VAIP(1)
where VAIP is an appropriately discounted, perpetual stream of earnings from the assets in place.
Under the assumption of no further growth, all earnings are equal to those in the current period.This assumption is nonrestrictive, since all future growth (either positive or negative) should end up in the V GO term.Data on market value and the value of assets in place are readily available, so the value of growth options VGO can be “backed out” from Equation (1). Real options theory has underpinned growth options value with strong theoretical foundations (Myers, 1977; Dixit and Pindyck, 1994; Trigeorgis, 1996). In this study, we will extend Equation (1) so that it incorporates irrational behavior in financial markets.
A company’s portfolio of real options can be valued “bottom-up” through the estimation of individual option parameters. This entails the use of binomial lattice (Trigeorgis, 1996) or simulation models (Longstaff and Schwarz, 2001) making it possible to adjust the option valuation to case-specific characteristics (Copeland and Antikarov, 2001). In reality, a firm’s growth opportunities consist of a complex combination of growth options resulting from intra-firm option interactions. The combined value of an options portfolio is typically not the sum of the options (Trigeorgis, 1996) and real options should occasionally be combined sequentially, sometimes in parallel and sometimes not at all (Childs, Ott, and Triantis, 1998). Two merging firms complicate the options portfolio even further. To avoid estimating option and interaction parameters, we follow a less involved “top-down” approach usingthe financial market information of publicly listed firms and calculating the combined growth options value embedded in the stock price.
Differences in growth options value were first empirically studied by Kester (1984). More recently, growth options value has been related to systematic risk (Chung and Charoenwong, 1991); R&D, uncertainty, and the skewness of returns (Smit and Van Bekkum,2011); to the pricing of initial public offerings (Chung, Minsheng, and Yu, 2005); to idiosyncratic risk (Cao, Simin, and Zhao, 2006); to firm, industry, and country effects (Tong, Alessandri, Reuer, and Chintakanda, 2008a); to downside risk of multinational corporations (Tong and Reuer, 2008); and to international joint ventures (Tong, Reuer, and Peng, 2008b).
This market-based measure for growth options value, however, hinges on the assumption that market prices adapt fully and immediately to price relevant information. This assumption is quite strong since the elusive value of growth options can easily be over or underestimated in financial markets. Any erroneous market pricing will introduce noise in the growth options value.Below, we will adjust the growthcomponent in Equation (1) to alleviate this issue.
C. Irrational Capital Markets
Due to market inefficiencies (Barberis and Thaler, 2003; Shleifer, 2000), the market price P in Equation (1) may not reflect fundamental firm value. Corporate managers have superior information about their own firm (Muelbroek, 1992; Seyhun, 1992) and rational managers can gain by timing anomalies that result from irrationality in the markets (Jenter, 2004; Baker and Wurgler, 2002). Managers may also cater to short-term investors by maximizing appeal (Baker et al., 2007). In these situations, managers influence the market value of a firm without creating fundamental value. In a takeover context, when potential market value deviates from fundamental values, takeover activity may be strongly related to stock market valuation (Rhodes-Kropf and Viswanathan, 2004; Dong, Hirshleifer, Teoh, and Richardson, 2006). In particular, Gao (2010) finds that long horizon managers tend to exploit overvalued stock prices by making equity transactions. This is in line with previous evidence regarding information asymmetries. Firms issue equity when they are overvalued or expect poor future performance (Fu, 2010)as acquisitions are, in effect, a form of equity issuance (Ritter, 1991; Loughran and Ritter, 1995; Jenter, 2004).
Empirical studies regarding overvaluation typically separate market value into an intrinsic portion and a mispricing portion. A popular proxy for mispricing is the market-to-book ratio (M/B) (Barberis and Huang, 2001; Daniel, Hirshleifer, and Subrahmanyam, 2001; Bloomfield and Michaely, 2004; Dong et al., 2006; Rhodes-Kropf et al., 2005). For instance, Rhodes-Kropf et al.(2005) find that bidders have a larger M∕B than targets, but both have higher M∕Bs than non-mergers. Alternatively, Dong et al.(2006), who report more studies that use M∕B in this context, compare a firm’s market-to-book ratio with its market-to-value ratio, where value is measured as a perpetual stream of (forecasted) earnings. They too find that both bidders and targets have high market-to-book ratios due to mispricing. Our findings are consistent with both studies.
In addition to mispricing, however, the market-to-book ratio is also a well known proxy for growth opportunities (Berk, Green, and Naik, 1999; Anderson and Garcia-Feijoo, 2006). Therefore, in terms of market-to-book, over pricedbidders and targets, as in Rhodes-Kropf et al.(2005), may also be bidders and targets with a large potential for economic growth. Dong et al.(2006) address this issue by measuring intrinsic value, and find that targets are less overvalued and have a lower M∕B ratio. Failure to compareM∕B with non-merging firms, however, does not explain the selection of targets from a growth options perspective. Therefore, we will resort to a different, cleaner measure than M∕B and compare it among bidders, targets, and non-merging firms. Our approach indicates that market-to-book consists of both growth opportunities and mispricing, and that this distinction is of great importance when analyzing takeovers.
III. Hypotheses
A. Bidders are Over Valued
Several takeover motives exist that are related to share prices, but many of them are not aimed at creating fundamental value. For instance, Myers (1976) confirms that takeovers may boost short-term earnings pershare, but depress long-term growth.More recently, Rhodes-Kropf and Vishnawanathan (2004) propose a theory that explains why merger waves occur during valuation waves.In their model, the overall valuation error of share prices leads to the overestimation of synergies after a takeover. In addition, Shleifer and Vishny (2003) argue that bidders are overvalued relative to the target, and buy smart using their overvalued stock. As such, firms may inexpensively acquire targets by taking advantage of financing with their overvalued equity.[3]What these models have in common is that managers maximize firm value when financial markets may not represent company valueleading to the following empirical observation that serves as a building block for further theoretical reasoning.[4]
Empirical Observation:Bidders are over priced relative to non-merging firms.
This empirical observation has implications for a company’s growth options value. When markets fail to price growth options correctly, the growth options value tends to be over priced and conventional growth options measures may at times be inappropriate. This bias is likely to differ over time and across industries.The surveyed literature on mispricing indicates that it is also associated with takeover activity. Mispricing arguments state that market value in excess of fundamental value is a pricing error. The implication is that while the growth options value may be large, it would be substantially smaller if it could be backed out from the fundamental value, instead of the overvalued market price in Equation (1).
B. Bidders Buy Smart
As noted, a company can be viewed as a basket of assets and growth options. Valuable growth options from the merging bidder and target can be an important rational reason to bid.One such example would be when the acquirer can create synergies and provide instant access to many new resources and capabilities. Organic growth options may be present in either party as they result from novel technologies or re-shaped market conditions (Bettis and Hitt, 1995). When the value of the company’s growth options develops favorably (e.g., positive changes in product demand and further development of technological trajectories), a firm appropriates future profits by exercising its options through investment. In addition to these embedded growth options that are complementary to the bidder, a target may also provide an initial foothold in a market with high entry barriers as in Miller and Folta (2002), or function as a platform for follow-on acquisitions (Smit, 2001, Smit and Moraitis, 2010). The target then generates additional growth option value to be obtained through follow-on acquisitions.