Home Country Macroeconomic Influences on Outward Cross-Border Mergers and Acquisitions

Home Country Macroeconomic Influences on Outward Cross-border Mergers and Acquisitions: Evidence from the UK

Abstract

Prior studies examining the trends of mergers and acquisitions (M&As) have concentrated on host country macroeconomic influenceswith relatively little attention on home country. In this paper, we use a non-linear modelling approach, the Exponential GARCH(EGARCH) model, to investigate dynamic effects of macroeconomic shocks on the UK outward M&Asover the period 1987Q1 to 2008Q1. Our results indicate that a number of home country macroeconomic variables, includingeconomic output, producer price, broad money supply and real effective exchange rate play an important role in explaining the trends of cross-border mergers and acquisitions outflows by the UK firms. The findingssupport the notion that home country macroeconomic factors can create the advantages to improve theoutward Cross-border M&A activities.

Keywords: cross-border, mergers and acquisitions, macroeconomic factors, EGARCH, UK

JEL Classification:

1. Introduction

The increasing significance of macroeconomic factors in explaining the location of international production activity in the 1990s in the host country has been highlighted in the literature (see Dunning, 2009; Vasoncellos and Kish, 1998; Uddin and Boateng, 2011). In comparison, studies looking at the relationship between home country macroeconomic fundamentals and aggregate mergers and acquisitions remain sparse(Neto et al., 2010, Tolentino, 2010). The emphasis of host country macroeconomic influences on the inwards M&As appearsreasonable in that, macroeconomic factors constitute a major component of location attractiveness of thehost countryin question (Dunning, 2009). Green and Meyer (1997); Oxelheim et al., (2001) argue that the host country macroeconomic policy environment may increase or decrease the cost of doing business in the host country. This is consistent to the theoretical prediction that, capital should flow into countries which offer favourable environment in terms of macroeconomic attractiveness. In contrast, the relationship between outward M&As and home country factors appears unclear and controversial. In this study, we argue that the environmental factors associated with a firm’s country of origin are crucial, even if partially, to the development of a firm’s competitive advantages by providing the context in which firm choices are made. Our question therefore is: do home country macroeconomic factors have explanatory power for the cross-border mergers and acquisitions outflows? This paper attempts tomodel the relationship between a selected home country-specific national macroeconomic factors and thelevel of CBM&A activitiesby UK firms using nonlinear time series model.Specifically, we use the ARCH type model to examine the dynamic effects of macroeconomic shocks on the UK outward M&As over the period of 1987-2008. This is significant in that, financial time series, such as stock prices and exchange rates have a tendency to exhibit clustering of volatility along with leptokurtic unconditional variances. Moreover, prior studieshave used linear time series models to examine macroeconomic influences on M&As (see Shugart and Tollison, 1984; McCann, 2001; Yagil, 1996). Relatively, few studies have used non-linear time series models to capture wave behaviours in M&A (see Resende, 1999; Carow, Heron and Saxton, 2004; Boateng, Naraidoo and Uddin, 2011). Town, 1992 and Resende, 1999 argue thata more promising line of research is to extend the non-linear time series models that naturally accommodate the dynamics associated with waves and patterns of mergers and acquisitions behaviour. Responding to that call, this study uses EGARCH to capture the relationship between macroeconomic factors and the outward M&As by UK firms. In this model, the time-dependent volatility is modeled via some deterministic equations.

The choice of the United Kingdom is driven by two reasons: First, UK provides a unique setting and dataset as a leading European country in the international market for corporate control for the analysis of macroeconomic factors as evidenced in Table 1. The Table indicates that the UK holds the top position of CBM&As among the European Union countries. Despite the rise and fall in trends in outward M&A activities, the Table indicates that the UK is ahead of other leading countries in the EU such as Germany and France in terms of volume of CBM&As.

(Insert Table 1 here)

Second, as a non-member of the European Single Currency, the UK sets it own interest rates and other macroeconomic policies and that allow us to see the full and clear impact of the role of macroeconomic influences on outward M&Aoutsidethe European Single Currency.

Our results show a strong explanatory power of a number of home country macroeconomic fundamentals on outward M&A activities. The results show the important role played by home country macroeconomic factors and support the notion that home country macroeconomic factors create competitive advantages on which firms investment decision are made.

The rest of the paper is organized along the following lines. The next section summarises the literature and develops the hypotheses of study. Section 3 presents the data and themodelling framework that accounts for the macro-economic influences on CBM&As. Section 4 presents the results and discusses the findings of the study. The last section provides a summary of the conclusion and discusses the implications of the study.

2. Literature Summary & Hypothesis

Scholars have examined and produced a myriad of reasons, at least in part, which may contribute to the growth ofM&Asat aggregate level including stock prices and inflation (Weston, 1953; Nelson, 1959; Evenett, 2003), gross domestic product (Becketti, 1986; Resende, 2008); interest rates ((Becketti, 1986; Ali-Yrkko, 2002). However, most of these studies tend to examine the relationship between host country macroeconomic variables and inward M&Aswith relatively limited literature probing the contribution of home country macroeconomic factors influencing the growth of CBM&As(Nachum and Role, 1999; Nachum, 2001). Systematic research evidence indicates that internal influences associated with a firm’s assets and competencies are central to their competitive advantages and predominately explain their overseas expansion (Hawanini and Schill, 1982; Dunning 1981, 1988). However, it is also reasonable to conjecture that external factors play a role, albeit partially, in the development of a firm’s competitive advantages by providing the context in which firm choices are made. More recently, Dunning (2009) has reinforced the importance of external macroeconomic factors in explaining the international production activity within the OLI paradigm.This point isshared by Kalotay and Sulstarova (2010) who suggested that Dunning’s OLI paradigm is missing a fourth, ‘home country’ leg.This study builds on a premise that some of the firm’s ownership-specific advantages that drive outward M&A activities are likely to be derived, at least in part, from external factors associated with a firm’s country of origin (seeNachum and Role, 1999; Kalotay and Sulstarova, 2010).We provide the hypotheses of the study below.

2.1 Stock Prices

The pioneering work of Weston (1953) and the subsequent one by Nelson (1959) suggest that stock price exert a significant influence on aggregate M&A activities. In a study of stock prices over the 1895-1920 period in the U.S. market, Nelson (1959) found a positive correlation between changes in the merger activities and changes in the stock prices. Using overvaluation hypothesis, researchers such asShleifer and Vishny, 2003; Baker et al., 2009 have rendered some support for the relationship between stock prices and M&A activities. Shleifer and Vishny (2003) point out that during stock market boom, share prices of some companies tend be overvalued. To protect the interest of the shareholders from any subsequent fall in share prices, managers exchange the firm’s overvalued shares to acquire real assets via acquisitions. Baker et al. (2009) concur and argue that CBM&As could occur for similar reasons, that is,overvalued stock in the home country may be used in acquisition of firms abroad. Baker et al. (2009) termed this as ‘cheap financial capital hypothesis’ and used similar arguments put forward by Shleifer and Vishny (2003) to explain the role of stock prices on aggregate CBM&As activities. In similar vein,Vasconcellos and Kish (1998) in their study found that adepressed US stock market relative to foreign stock market encourages foreign acquisitions of US companies. Oster (1990) suggested that firms would pursue M&As more than any other entry mode when the target shares are under priced. It is important to point out that numerous empirical studies such as Vasconcellos and Kish (1998; 1996), McCann (2001) and Kish and Vasconcellos (1993) also found that stock price movement influence CBM&As flow, however the direction of the movement appears inconclusive.

In the context of the UK, Uddin and Boateng (2011) argue that there have been periods where stock prices have tumbled such as the UK withdrawal from European Exchange Rate Mechanism, the technology bubbles and the 1997 financial crisis in Asia. Likewise, they pointed out that there have also been periods of buoyant stocks in bull market and all these have implications for the behaviour patterns of investors. Given the length of growth witnessed in the UK, we hypothesised that:

H1: The relationship between UK stock prices and the UK CBM&As outflows will be positive

2.2 Gross Domestic Product

A number of studies have found a positive relation between size of the host economy and FDI inflow, however, we know very little about the relation between size of the home economy andCBM&As. Drawing on the literature that relates GDP with outward FDI, Vasconcellos and Kish (1996) pointed that in times of prosperity, a firm is well positioned to engage in international expansion through M&As. This is because higher GDP may result in higher level of cash reserve in the hands of firms which may encourage them to acquire companies abroad. Given that, the UK has witnessed a huge expansion in its economy, particularly, in late 1990s and in the last decade, we hypothesised that:

H2: There will be a positive relationship between GDP and outwards M&As

2.3 Interest Rates

The role of interest rate in the home country in stimulating investments across the border has been recognised in both finance and international business literature. According to Moeller and Schlingemann(2005) the cost of financing influences acquisitions hence interest rate becomes dominant factor in making international acquisition decisions. The aboveis supported by Tolentino (2010) who argued that, relatively low interest rates are associated with a home country’s capital abundance and forms an important impetus for capital investment outflowabroad to diversify and enhance the level of profitability. Empirical studies that examined the effect of home country macroeconomic factors in respect of FDI outflows also suggest that home country interest rate as a significant factor that explains part of the FDI outflows. For example, Aliber (1970) and Grosse and Trevino (1996) pointed out that lower financing cost is a major source of competitive advantage for firms to pursue FDI. Using a broader measure of capital costs, Barrell and Pain (1996) found a positive relationship between relative capital costs and outward foreign direct investment of which CBM&As is an important part. Pablo (2009); Forssbaeck and Oxelheim (2008) support this view and suggest that the ability of a firm to undertake cross-border investment can be explained by the cost of and access to capital. For example, the availability oflower cost of external funds creates a financial synergy and increases the likelihood of acquisitions (Uddin and Boateng, 2011). On the relationship between interest rate and outward M&A activities, scholars argue that the relationship lies with the fact that lower interest rates reduces the cost of financing at home due to capital abundance. On the other hand, it may be argued that, in efficient financial markets, no firm has a financial advantage over another, since all firms have equal access to finance at equal (risk-adjusted) cost (Forssbaeck and Oxelheim, 2008). However, this argument is based on the assumption of imperfect capital markets that are at least partially internationally segmented. In the light of the above argument, we hypothesised that:

H3: Interest rate in the UK has a positive influence on CBM&As

2.4 Money Supply

Neoclassical theories emphasise the role of economic, technological and regulatory shocks in explaining merger waves (Gort, 1969; Mitchell and Mulherin, 1996). However, Harford (2005) points out that these shocks are not enough to generate merger waves and further argue that there must be sufficient capital liquidity to accommodate the asset reallocation. According to Harford (2005), the increase in capital liquidity and reduction in financing constraints must be present to generate merger wave by economic, technological and regulatory shocks.Following theearlier work by Shleifer and Vishny (1992) regarding liquidity, this study uses money supply as a proxy for overall liquidity. Shleifer and Vishny (1992) argued that one of the potential determinants of liquidity is the number of buyers in the market. From a macroeconomic perspective, increased money supply in the economy in a given period of time enhances the number of buyers in the market by affecting the disposable income or the cost of borrowing.The role of liquidity in stimulating aggregate M&As activities has also been emphasised by a number of scholars including Resende (2008), Clarke and Ioannidis (1994) and Fishman (1989).However, the influence of liquidity in respect of the aggregate flow of CBM&As is scarcely discussed in the literature. From a theoretical perspective, increased level of liquidity should affect the CBM&As outflows positively. For example, an increased level of liquidity in the home country will facilitate assets reallocation and given that the supply of domestic targets is constant, this leads to an increase in outward CBM&As. From the above discussions, we put forward the following hypothesis:

H4: Money supply is positively related to outward M&As by UK firms

2.5 Exchange Rate

Valuation hypothesis of M&As states that acquisitions will take place because of valuation differences between target and bidding firms. Erel et al. (2011) pointed out that given that markets in different countries are not perfectly integrated, valuation differences across markets can motivate CBM&As. One of the potential sources of value difference is the changes in currency value or exchange rates. For example, if the home currency appreciates in value relative to host currency, then firms from home country will find firms in the host country relatively cheaper leading to more acquisitions of firms in the host country.The above is consistent with the view put forward by Vasconcellos and Kish (1996) who suggest that the relative strength or weakness of the domestic currency pari-pasu the foreign currency plays an important role in the M&A decision-making process. Exchange rate has impact on the effective price of the transaction, its financing, the costs of managing the acquired firm and the profits to be repatriated to the acquirer firm (Weston et al., 1990). The above arguments also support the classical work of Froot and Stein (1991) who argue foreign firms are wealthier relative to domestic ones when dollar is depreciating and we should observe a negative relationship between inward acquisitions and exchange rate and the converse is true if dollar is appreciating. Studies by Harris and Ravenscraft (1991), Kang (1993), Dewenter (1995) and Goergen and Renneboog (2004) have also rendered some support for this notion and pointed out that firms from countries with appreciating currency should act as an acquirer whereas firms from countries with depreciating currency should be a target on the grounds that strong currency would reduce the acquisition price and transaction costs. Consistent with these findings, Nisbet, Thomas and Barrett (2003) found that the UK firms acquired more firms in U.S. when the pound was stronger against US dollar. In an attempt to shed to shed more lights on the relationship between exchange rate movements and foreign acquisitions by Japanese firms in the United States, Blonigen (1997) found that real exchange rate depreciations of a dollar to the yen results in substantial increases in acquisition FDI involving firms that tend to have firm-specific assets. While past empirical efforts such as Caves, 1989; Froot and Stein, 1991 have found correlation between dollar depreciations and increased FDI, others including Stevens, 1992; Healy and Palepu, 1993 have found little support. To Cushman (1985) the relationship between exchange rate movement and acquisitions remains unresolved and therefore an empirical question.Given that the pound sterling has been a strong currency over the past two decades, we hypothesised that:

H5: The UK exchange rate will positively influence the outward M&As by UK firms

2.6 Inflation

Gugler et al. (2011) argue that when firm’s return on its capital exceeds cost of capital then q is greater than one and this leads the firms to acquire more assets either in the form of capital investments or acquisitions of other firms. Inflation in economy affects both the return on investments and also the cost of capital and thereby affects the acquisition decision of any individual firm. For example, McKinnon (1973) pointed out that at higher rates of inflation, money is more costly to hold, so the net return from investment is lower. On the other hand, Fisher equation of nominal interest rate shows that nominal interest rate which is a measure of cost of capital is always higher than real interest rate in the presence of inflation. Therefore, the presence of high inflation in the home country discourages domestic acquisitions by negatively affecting the firm’s qthereby reducing return on investments and increasing cost of capital. The alternative of firm is to invest abroad where the inflation is lower. Lower inflation in the host country relative to home country will help boost the q ratio and will increase the volume of acquisitions activity. Sayek (2009) also found that changes in inflation rates of the domestic or foreign country tend to alter the net returns and optimal investment decisions of the multinational enterprises (MNEs). In the presence of inflation, MNE minimises the negative effects of inflation by changing location of production based on the extent of inflation between home and host country. Although the role of inflation in explaining aggregate CBM&As flow is important, there exists few studies in the UK context. Given the consistently low rate rates of inflation in the UK over the past decade, it is important we investigate the relationship between inflation and the rising trends of CBM&As in the UK. We hypothesise that: