M&A activity Flashcards
What are the two approaches of behavioral corporate finance?
- Some investors are less than fully rational.
2. Managers can be less than fully rational.
Irrational investors approach
- Limits to arbitrage - prices can differ form fundamental values.
- Investors can influence security prices.
- Rational managers can identify mispricings and try to exploit them. Superior information.
Fewer constrains than money managers.
Experience, knowledge and ability to manufacture information advantage. - What can managers do to exploit mispricing?
If stock is overpriced: Issue equity, equity financed acquisitions If stock is underpriced: Stock buybacks
Irrational managers approach
This approach studies managerial behavior that departs from rational expectations and expected utility maximization, but the manager continues to believe that he is maximizing firm value.
Should not be confused with rational moral hazard managerial behavior (empire building or stealing) or agency costs.
Building elements:
1. Rational investors, but with limited governance mechanisms.
2. Main biases: optimism and overconfidence.
Applications of behavioral corporate finance
- Investment policy:
- Real investments.
- Mergers and acquisitions. - Financial policy:
- Equity issues (IPOs, SEOs).
- Share repurchases.
- Debt issues. - Other corporate decisions:
- Earnings management.
- Firm names
Problem of behavioral corporate finance irrational manager and irrational investor
The two approaches give opposite normative implications:
1 Irrational investors approach recommends isolating managers from short-term share price pressures.
2 Irrational managers approach recommends reducing discretion and obligating managers to respond to market price signals.
Winner’s curse in auctions
In common value auctions with incomplete information, the winner will overpay.
Hubris explanation (irrational manager) of M&A activity
1) It implies that managers seek to acquire firms for their own personal motives and that the pure economic gains to the acquiring firm are not the sole motivation or even the primary motivation in the acquisition.
2) Roll (1986) states that if the hubris hypothesis explains takeovers, the following should occur for those takeovers motivated by hubris:
3) The stock price of the acquiring firm should fall after the market becomes aware of the takeover bid.
4) The stock price of the target should increase with the bid for control. This should occur because the acquiring firm is not only going to pay a premium but also may pay a premium for excess of the value of the target.
5) The combined effect of the rising value of the target and the falling value of the acquiring firm should be negative. This takes into account the costs of completing the takeover process.
Malmendier and Tate (2006): Test of hubris hypothesis
Optimistic CEOs complete more mergers, especially diversifying mergers.
Optimism has its biggest effect among the least equity dependent firms.
Investors are more skeptical about offers made by optimistic CEOs.
Schneider and Spalt (2017): Test of hubris hypothesis
CEOs gamble because acquirer announcement returns are much smaller : If the CEO is more entrenched.
If the CEO is younger or more prone to gambling.
If the firm has performed poorly over the last 12 months.
If the difference of the current stock price to the 52-week high is large. If the firm has reported negative earnings at the last fiscal year end.
Neoclassical Q theory - more productive use of assets.
Rhodes-Kropf and Viswanathan (2004) - correlated asymmetric information. Shleifer and Vishny (2003) - irrational investors and self-interested target managers.
Main Findings?
1) Level of merger activity:
- Activity during merger waves dominated by highly overvalued bidders.
- Acquirers and targets cluster in overvalued sectors.
- Misvaluation explains about 15% of merger activity at the sector level.
- Neoclassical theories also highly relevant (like productivity shocks).
2) Which company is acquirer and which one is target?
- Acquirers have significantly higher firm-specific error in M/B than targets.
- Firms with higher firm-specific error act as acquirers and use stock payments.
3) Transaction medium:
- Cash targets are undervalued, while stock targets are overvalued.
- Cash acquirers are less overvalued than stock acquirers (both overvalued).
4) Long-term effects:
- Low long-run value-to-book firms buy high long-run value-to-book firms. - Why targets accepts the offers?
Rhodes-Kropf and Viswanathan (2004): explanation
There is misvaluation.
Rational explanation why targets accept an overvalued stock as acquisition currency.
Rhodes-Kropf and Viswanathan (2004):
Rational managers with asymmetric private information.
- Cannot distinguish between firm-specific mispricing and market overvaluation.
- Fiduciary responsibility to accept any offer higher than stand alone firm value.
- High market-wide overvaluation leads to high error in estimating synergies.
Empirical predictions
- Relative level of misvaluation across transactions:
Overvalued firms buy relatively undervalued firms when both are overvalued. Firms in overvalued sectors buy firms in relatively less overvalued sectors. - Relative level of misvaluation and payment methods: Cash targets are more undervalued than stock targets. Cash acquirers are less overvalued than stock acquirers.
- Creating merger waves (merger intensity predictions):
Increasing misvaluation increases the probability that a firm is in a merger, is the acquirer, and uses stock as the method of payment.
Increasing sector misvaluation increases merger activity, and the use of stock as method of payment, in that sector.
Results - relative value predictions - Empirical prediction 1 - Overvalued firms use stock to buy relatively undervalued firms when both firms are overvalued:
Empirical prediction 1 - Overvalued firms use stock to buy relatively undervalued firms when both firms are overvalued:
Firms involved in mergers have higher total valuation error (firm specific plus time-series sector error).
Targets have lower firm-specific error than acquirers.
Driven by stock-financed acquisitions.
Results - relative value predictions- Empirical prediction 2 - Acquirers come from sectors that are more overvalued than targets:
Empirical prediction 2 - Acquirers come from sectors that are more overvalued than targets:
Acquirers have higher time-series sector error than targets. Holds for all transaction types.
Results - relative value predictions- Empirical prediction 3 - Transaction type matters:
Cash targets are more undervalued than stock targets. Cash acquirers are less overvalued than stock acquirers.
