Market valuation and cross- border M&A quality. Master thesis finance Tilburg School of Economics and Management Department Finance Tilburg University Name: Sven Rustenhoven ANR: 501168 Student number: U1255546 Supervisor: prof. dr. J.J.A.G. Driessen Date: 26 September 2014
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Market valuation and cross-
border M&A quality.
Master thesis finance
Tilburg School of Economics and Management
Department Finance
Tilburg University
Name: Sven Rustenhoven
ANR: 501168
Student number: U1255546
Supervisor: prof. dr. J.J.A.G. Driessen
Date: 26 September 2014
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Table of contents
Introduction 3
Section 1. Mergers and Acquisitions 5
1.1 M&A history 5
1.2 Rationale for mergers and acquisitions 6
Section 2. Cross-border M&A and Market Valuation 9
2.1 Cross-border M&A 9
2.1.1 Cross-border versus domestic M&A 10
2.1.2 Cross-border M&A and method of payment 11
2.1.3 Empirical evidence on cross-border M&A returns 11
2.2 Market valuation 12
Section 3. Hypotheses 14
3.1 Hypotheses 14
Section 4. Data 18
4.1 Data 18
4.2 High-, neutral-, and low-valuation markets. 18
4.3 Summary statistics 20
Section 5. Methodology 22
5.1 Announcement returns 22
5.2 Multivariate regression framework 23
5.3 Control Variables 25
5.3.1 Method of payment 25
5.3.2 Diversifying and focused M&A 26
5.3.3 Tender offer 27
5.3.4 Private and public targets 27
Section 6. Results 29
6.1 Univariate announcement results 29
6.2 Multivariate regression results 31
Section 7. Conclusion 39
References 41
3
Introduction
During the last few decades cross-border mergers and acquisitions (M&A) became more
important as a tool for firms to achieve their strategic and business objectives. Since the
nineteen-eighties cross-border mergers and acquisitions share of worldwide foreign direct
investment (FDI) increased by around 50 percent. In 1987 M&A made up around 52 % of
global FDI. This increased to 83% in 1999 and after 1999 this fluctuated between 80 and
85% of global FDI (UNCTAD, 2008). Cross-border mergers and acquisitions have a sizeable
impact on the global economy because FDI makes up between 2 to 4% of the world economy
in the last decade (World Bank Group, 2014).
Research about the wealth effects of mergers and acquisitions and the influence of
certain deal characteristics on the activity and quality of mergers and acquisitions is plentiful
over the last few decades. According to Martynova and Renneboog (2005) evidence on the
returns for targets is conclusive. Returns are often significant and positive for the
shareholders of the target firms, whether it is a European, UK, or US firm. For shareholders
of the acquiring firm the abnormal returns are mixed (Martynova and Renneboog, 2005).
Research shows that several deal characteristics influence the returns of acquirers. These
characteristics are for example: method of payment, type of the target, and the mode of the
M&A (Bouwman, Fuller, and Nain, 2009). Acquirersโ stock returns of domestic deals
outperform acquirersโ returns of cross-border deals (Conn et al, 2005). Target firms involved
in domestic M&A have generally lower abnormal returns than target firm involved in cross-
border M&A (Conn et al, 2005).
A distinctive mark of M&A is that it occurs in waves and has a tendency to cluster by
industry within each wave (Andrade, Mitchell, and Stafford, 2001). A lot of research has
been conducted on M&A activity and waves. For example: the relation between stock prices
and M&A waves. Jovanovic and Russeau (2001) develop a model that explains the positive
correlation between M&A waves and market valuation. Bouwman, Fuller, and Nain (2009)
take a look at the relationship between market valuation and the quality of M&A deals. They
find that in high-valuation markets U.S. acquirers have higher returns at announcement than
acquirers in low-valuation markets. They also find that acquirers have higher long-term
abnormal stock return in low-valuation markets than those buying in high-valuation markets.
It is interesting to see what happens to the, previously mentioned, results from
Bouwman et al. (2009) when the sample is split between cross-border and domestic M&A.
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This paper investigates if cross-border mergers and acquisitions undertaken in booming stock
markets differ in quality from those undertaken when stock markets are depressed. Also this
paper tries looks at the influence of cross-border characteristic on the quality of mergers and
acquisitions. This research investigates if a specific valuation state has influence on cross-
border merger and acquisition quality.
The rest of this paper is outlined as follows. Section 1 contains a brief overview on the
history of mergers and acquisitions. It also covers the rationale for mergers and acquisitions.
Section 2 covers the primary characteristics of this research, cross-border and market
valuation. Here theory and empirical evidence will be covered. The content of section 2
forms the basis for the hypotheses, which is outlined in section 3. Section 4 comprises the
data and summary statistics, and how to distinguish different market-valuation states. The
methodology used is covered in section 5. Also, section 5 provides some theory on the
control variables. Section 6 comprises the results and a discussion of the results. Section 7
holds the summary and conclusions.
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Section 1. Mergers and Acquisitions
1.1 M&A history
Golbe and White (1993) find evidence that US M&A activity comes in waves and follow a
cyclical pattern. Martynova and Renneboog (2005) distinguish five M&A waves: those of the
early 1900s, 1920s, 1960s, 1980s, and 1990s. Most of the scientific research on M&A makes
use of US and UK transactions. This is due to the fact that in the last era most of the M&A
activity took place in the US and UK and data is easily accessible. Only in the last wave, the
1990s wave, Europe could match the quantity and value of the UK and US wave.
The first two waves, those of the 1900s and the 1920s, solely occurred on US soil.
The first wave occurred after a period marked by great economic expansion, which was
followed by a period of stagnation. This wave led to an economic environment dominated by
a few firms, also known as a monopoly. This horizontal consolidation led to the
disappearance of more than 1800 firms. The second wave was a reaction of the competitors
on the few firms having monopoly powers. The competitors merged or were forced to merge
together, creating an oligopoly (Sudarsanam, 2010, chapter 2).
The third wave, during the 1960s, in the US was focused on growth through
diversification. This could be due to the stronger antitrust rules that did not allow market
power increasing horizontal or vertical mergers. At the same time the first UK merger wave
took place. Horizontal mergers characterized this wave. The reason for the dominance of
horizontal mergers could be due to the fact that the UK government adopted policies to make
UK firms big national firms so they could compete with the rest of the world (Sudarsanam,
2010, chapter 2).
The fourth US wave reversed the mergers undertaken in the third wave. This wave is
characterized by acquisitions and divestures. Firms focused more on their core business and
tried to exploit their competitive advantage. This was achieved by divesting in non-core
activities. Further, firms acquired firms and activities in which they already had a competitive
advantage. This wave introduced the hostile tender offer and the acquisition of diversified
firms. These diversified firms were dismantled and individual parts were sold. The size of
acquisitions increased tremendously compared to earlier waves. This was partially caused by
the emergence of private equity firms and thus an increase in takeover capital. At the same
time in the UK the third wave was going on. The deregulation of the financial sector in the
UK led to a huge inflow of US (investment) banks. They had more sophisticated and
developed techniques than the UK banks. US and European financials swallowed up most of
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the UK financials. These financials transformed the M&A landscape in the UK. They
employed more aggressive hostile deals and predatory tactics. The fourth wave was the first
global merger wave. (Sudarsanam, 2010, chapter 2).
The fifth wave in the US occurred at the end of the 1990s and the beginning of 2000s.
It is the biggest wave, measured in value, so far. This had several reasons including: new
technologies such as the internet, the globalization of product, services, and capital markets,
lower trade barriers through the foundation of the WTO and big trading blocs, deregulation of
industries, and the objective of maximizing shareholder value. This wave is characterized by
the huge individual deals that were made in for example the telecom sector. The view that
focussing on core competences is the source of competitive advantage continued from earlier
waves through to the fifth wave. The 1990s wave in the UK and the wave in Europe have
equal characteristics. Many state-owned enterprises were privatized and deregulation took
place in many sectors (Sudarsanam, 2010, chapter 2).
The sixth and last wave occurred in the new millennium. In the US, UK, and Europe
the wave was smaller than the previous wave. It was characterized by the increased
importance of private equity acquirers, the emergence of hedge funds, and increased
shareholders activism.
1.2 Rationale for mergers and acquisitions
Research argues that M&A activity is caused by industry-level shocks (Jensen, 1986).
Mitchell and Mulherin (1996) found evidence that deregulation, oil price shocks, foreign
competition, and financial innovations explain a significant piece of M&A activity in the
1980s (Andrade, Mitchell, and Stafford, 2001). The rational view within economics sees
optimizing shareholder value of public firms as reason for individual mergers and
acquisitions. This model sees mergers and acquisitions as a tool for managers to increase
shareholder value.
The rationale behind this model can be found in four different motives. The first
motive is synergy. Managers of the acquiring firm believe that the stock price of the target is
accurate but think they can add value through synergies. According to Martynova and
Renneboog (2006) takeovers are expected to create financial synergies and operating
synergies. Financial synergies are argued to benefit a diversifying takeover. A diversifying
takeover presumable ad stability to the cash flows of the acquirer. These more stable cash
flows and the increase in firm size after the takeover are associated with easier access to,
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more and different, capital markets and a lower cost of capital. Also, more stable cash flows
leads in turn to a lower probability of the acquirer going bankrupt (Martynova and
Renneboog, 2006). When a firm acquires a target with high levels of cash this can result in
lower internal financing cost. External financing cost can be lowered by acquiring a target
that has lower financial leverage and unused debt capacity (Ghosh and Jain, 2000).
A takeover results often in a bigger firm that can make more and better use of
economies of scale en scope, vertical integration, the elimination of duplicate activities, and a
reduction in agency costs by bringing organization-specific assets under common ownership
(Martynova and Renneboog, 2006). Comment and Jarrell (1995) state that operating
synergies primarily effect same- or related-industry mergers and acquisitions. Operational
synergies include acquisition of new technology, technology, or intangible assets (Martynova
and Renneboog, 2006). The acquirer could also profit from the economy of learning by
taking over effective and already tested and employed practices from the target (Sudarsanam,
2010, chapter 3).
The second motive for an acquisition is to force discipline on the target. These
acquisitions are considered to often have a hostile nature (Martynova and Renneboog, 2006).
According to this motive the deal happens because the acquirer believes that the target firmโs
management underperforms and therefore the stock price and profits are below the potential
maximum. The bidder aims to increase profitability of the target by replacing the targetโs
management. According to Slusky and Caves (1991) profits can be increased by
implementing the following changes after the takeover and subsequent board removal: by
optimizing or stopping the suboptimal use of debt, by matching the opportunities the targets
has on the market and its policies, and by exploiting opportunities regarding sales and assets
that the former targetโs management refused to do. There is evidence that hostility may be a
result of the bidding process to attain the maximum outcome for the shareholders of the target
(Schwert, 2000).
The rationale for mergers and acquisitions is not always the maximization of
shareholder value. The principal-agent theory by Jensen and Meckling (1976) sees managers
as agents of the shareholders. Managers do not have the same objectives as shareholders.
They could pursue their own objectives and increase their own wealth at the expense of the
wealth of the shareholders. Shareholders can align the objective of the mangers with their
own objectives through writing, monitoring, and enforcing contracts with the managers or
hire someone to this for them (Sudarsanam, 2010, chapter 3). But the costs of monitoring and
enforcing the contracts could outweigh the profits of the alignment of incentives.
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Behavioral economists have come up with a different model. This behavioral agency
model takes into account the behavioral biases of managers. In this model managers could
suffer from hubris, overconfidence, and overoptimism. Hubris is arrogance; overestimation of
oneโs skill and capabilities. Also if a manager in severe degree arrogates accomplishments to
himself and blames failure on others or external factors. In case of Hubris managers genuine
believe that they have superior skills compared to other people and managers. Overoptimistic
manager underestimate the chance that danger of hazards affecting them or their decisions.
This all could lead them to overpay for the target or misjudge the amount of improvement
they are able to make compared to the previous, in their view underperforming, management
of the target (Sudarsanam, 2010, chapter 3; Roll, 1986).
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Section 2. Cross-border M&A and Market Valuation
A lot of research in finance on mergers and acquisitions tries to identify deal characteristics
that influence abnormal returns. Several influential characteristics that have been described
are: the method of payment, the public state of the target firm, friendly versus hostile deals,
relative size of the deal, and industry-relatedness in M&A. The theory and empirical evidence
on the aforementioned variables will be covered in section 5, because in this research they are
solely used as control variables. This section covers the theory and empirical evidence on the
influence that cross-border mergers and acquisitions and market valuation have on abnormal
returns and why. First the cross-border characteristic is covered. Second market valuation
will be explained.
2.1 Cross-border M&A
During the last few decades cross-border mergers and acquisitions (M&A) became more
important as a tool for firms to achieve their strategic and business objectives. A cross-border
M&A entails: โthe control of assets and operations is transferred from a local to a foreign
company, the former becoming an affiliate of the latterโ (UNCTAD, 2000, p. 99). Since the
nineteen-eighties cross-border mergers and acquisitions share of worldwide foreign direct
investment (FDI) increased by around 50 percent. In 1987 M&A made up around 52 % of
global FDI. This increased to 83% in 1999 and after 1999 this fluctuated between 80 and
85% of global FDI (UNCTAD, 2008). Cross-border mergers and acquisitions have a sizeable
impact on the global economy because FDI makes up between 2 to 4% of the world economy
in the last decade (World Bank Group, 2014).
Cross-border M&A gains terrain on other sorts of FDI like Greenfield investments,
joint ventures or other strategic alliances. The reason for the increasing popularity of cross-
border M&A when a firm engages in FDI can be found in several factors. The availability of
capital to finance acquisitions has increased tremendously. Also the increased sophistication
and growth of capital markets leads to easier and cheaper access to capital. Access to good
and cheap information increased with the explosion in technology. For example: the
invention of Internet, satellites, and more and cheaper travel opportunities. Establishment of
the European Monetary Union (EMU); 19 countries adopted the euro as common currency.
The absence of conflict between countries that have the worldโs biggest economies. All the
aforementioned reasons, and a lot more, resulted in less costs for firms to undertake,
establish, and maintain a cross-border M&A. So cross-border M&A got relatively more
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attractive compared to the less drastic Greenfield investments or strategic alliances, which
have as advantage that if things go wrong the loss would be relatively limited.
2.1.1 Cross-border versus domestic M&A
There are a few reasons why the returns from cross-border M&A could differ from domestic
M&A. The first reason is diversification. If the domestic market crashes, then the foreign
market might not plummet as deep or not crash at al, and vice versa. The producing costs
could be lower due to lower wages, superior technology, or better access to (scarce)
recourses. Cross-border deals give a firm the opportunity to capture rents from foreign market
inefficiencies or due to a more beneficial tax environment (Scholes and Wolfson, 1990 as
cited by Martynova and Renneboog, 2006). Also, in the case of imperfect capital markets
firms could profit from exchange rate movements by moving operations to other countries
(Froot and Stein, 1991). More directly, (Markides and Ittner, 1994) argue that the model
developed by Froot and Stein (1991) can explain the link between cross-border acquisitions
and exchange rates. โThey, Froot and Stein, argue that given information asymmetries about
an asset's payoffs, entrepreneurs find it impossible or very costly to purchase the asset solely
with externally obtained funds. As a result, "information intensive" investments, such as
buying a company, will be partially financed by the net wealth of the entrepreneurโ. So when
the acquirerโs currency is strong compared to that of the target, then the acquirer has an
advantage due to increased purchasing power. This in turn should lead to higher returns for
the acquirer, because they pay less in their currency compared to what the value of the target
is in their opinion. Markides and Ittner (1994) find evidence that a relative strong currency
leads to higher returns of the acquirer.
However, cross-border M&A could encounter some disadvantages. Often regulations
and laws are very different in foreign countries. To adapt to these regulations and laws takes
time and money, whereby additional lawsuits and fines are also possible expenses. The
acquirer is dependent on the foreign and local government and institutions. Countries are far
from all stable democracies, sudden instability could lead to additional costs or even
complete loss of the foreign component of the firm. Correct valuation of the foreign target is
more difficult than a domestic target Conn et al. (2005). Targets located in overseas countries
or located in less developed countries are harder to valuate. Information is often not perfect
and hard and expensive to obtain. This all contributes to the chance that the bidder overpays
and destroys shareholder value.
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The factor that could influence the deal negatively is culture. When companies are
culturally dissimilar the returns could suffer from communication and information problems.
This leads to information and valuation problems before the acquisition. It could also give
problems after the acquisition in the form of slow or bad firm-integration. Research has been
conducted on this factor regarding cross-border mergers and acquisitions. On the
announcement-day there is a significant negative effect on the abnormal returns of the bidder
if the companies are culturally dissimilar (Chakrabarti, Gupta-Mukherjee, and Jayaraman,
2009 and Datta and Puia, 1995). However, in the long-run Chakrabarti et al. (2009) find a
positive effect on abnormal returns of the bidder if the companies are culturally dissimilar.
Conn et al. (2005) find that cross-border acquisitions with low cultural differences perform
relatively well.
2.1.2 Cross-border M&A and method of payment
Most of the empirical evidence suggests that cash deals outperform equity deals (see
paragraph 2.1). For cross-border deals this could not be the case because other factors
influence the method of payment. As Conn et al. (2005) state:โ For example, the use of equity
by cross-border acquirers may be due to the greater uncertainty connected with the
information problems associated with acquiring abroad. This may be especially true for
private overseas deals where the information may be even more imperfect. If bidder
shareholders recognize this reasoning then the usual positive impact of cash bids compared to
equity bids may be nullified.โ Also, refusal by the targetโs management of foreign equity, due
to information asymmetry, can lead to a forced cash bid (Gaughan, 2002 as cited by Conn et
al., 2005).
2.1.3 Empirical evidence on cross-border M&A returns
Empirical evidence on cross-border M&A returns can be split in two parts. First there are the
short-run announcement effects. Second, there are the long-term abnormal returns.
Conn et al. (2005) find that announcement returns of domestic acquisitions are higher
than those of cross-border acquisitions. Both domestic and cross-border acquisitions have
positive abnormal return. However, Conn et al. (2005) show that the former results depend on
the nature, is it a private or public firm, of the acquirer. When looking at public firms cross-
border deals have zero abnormal return and outperform domestic deals, which have negative
abnormal returns. When looking at private firms it is the other way around. Domestic deals
outperform cross-border deals and both have positive abnormal returns.
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According to Conn et al. (2005) there is limited empirical evidence on long-term
abnormal return in cross-border acquisitions. They mention four studies, Conn and Conell
(1990), Danbolt (1995), Black et al. (2003), and Aw and Chatterjee (2004), who look at the
abnormal returns on cross-border acquisitions of public firms. All these studies find negative
and significant long-term abnormal returns for the acquirers. Two other studies, Eckbo and
Thorburn (2000) and Gregory and McCorriston (2004), look at cross-border acquisition of
both public and private firms. They find no evidence of negative long-term abnormal returns.
Conn et al. (2005) themselves find that domestic deals have higher long-term abnormal
returns than cross-border deals.
2.2 Market valuation
Recent research investigates the possible link between stock price and M&A activity
and quality. First, this paragraph looks into theory and research of the correlation between
stock price and M&A activity. Secondly the theory of possible correlation between stock
price and M&A quality is treated.
Rhodes-Kropf and Viswanathan (2004) developed a model to describe stock M&A activity
and stock price. Through private information this models shows that there is a correlation
between M&A activity and stock price. They suggest that targets make mistakes when
valuing synergies in non-normal market conditions. The model involves rational managers,
who have information at firm- and market-level, and inefficient markets. This information
tells bidders and targets about their own misvaluation, but they have no information if this is
due to firm-specific reasons and/or due to market reasons. So bidders rationally adjust the
stock offer for potential misvaluation of the bidder. However, the target behaves as a
Bayesian and therefore assigns some probability to synergies too. So, the greater
overvaluation of the market, the greater is the estimation error of the synergy. This increases
the chance that the target accepts bids. So overvaluation at the market level increases the
chance that the target overestimates the potential synergies due to underestimation of the
misvaluation (Rhodes-Kropf, Robinson, and Viswanathan, 2005). Empirical evidence that
market valuation and in particular market misvaluation drives M&A activity was found by
Rhodes-Kropf, Robinson, and Viswanathan (2005). They also find that firms with a high
market-to-book ratio pay with stock more often than firms with a lower market-to-book ratio.
Theory and empirical evidence about the correlation between stock price and M&A
quality is covered below. Jovanovic and Rousseau (2001) develop a model that explains the
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positive correlation between M&A waves and market valuation. Bouwman et al. (2009)
investigate the quality of mergers and acquisitions that are made during different market-
valuation states. They find that in high-valuation markets U.S. acquirers have higher returns
at announcement compared to acquirers in low-valuation markets. They find opposite results
when examining the long-term abnormal returns. In this case acquirers have higher long-term
abnormal return in low-valuation markets than those in high-valuation markets. Bouwman et
al. explain the lower long-run abnormal returns for acquirers in high-valuation markets
through managerial herding. Managerial herding suggests that at the moment that mergers or
acquisition by early acquirers are shown to be successful, other firm want to make a similar
move. This puts more pressure on the possible synergies in takeovers made by these late-
movers. Also, the late movers could be affected by the possibility that the premium-quality
deals/targets are already picked up by the early-movers and the remaining deals/targets are of
less quality. Managerial herding suggests that merger waves tend to end at the moment firms
observe the long-term bad results from (late) acquirers. By this time many value-destroying
acquisitions are already made. Thus, managerial herding suggests that acquirers who move
late perform relatively worse compared to acquirers who move earlier. Bouwman et al.
predict and find evidence that managerial herding is primarily present during merger waves
that accompany booming stock markets.
Goel and Thakor (2010) have a different approach to explain the link between M&A
activity and M&A quality. They developed a model based on CEO envy. Their model
suggests that after a shock, which causes the first deals, the envy of CEOโs kicks in and
makes them want a bigger firm, higher pay, and be more prestigious than their competitors.
This also leads to value-destroying acquisitions, which are executed mostly at the end of a
takeover wave. They predict that this behaviour leads to smaller synergies for deals made in
bull markets compared to those made during bear markets.
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Section 3. Hypotheses
In this section the hypotheses will be formulated and substantiated with arguments. This
research only looks at acquirersโ abnormal returns around the announcement date, so all
references to returns are from the acquirersโ perspective.
3.1 Hypotheses
1. Are the average announcement period abnormal returns for acquirers positive or
negative?
Neoclassical economics sees mergers and acquisitions as a way to improve efficiency and
ultimately increase shareholder value. This basic assumption of this theory is that the
combination of bidder and target is worth more than the sum of their standalone value. This
can be due to: synergies, both financial and operational, economies of scale and scope, or by
replacing poor management. According to these arguments abnormal returns for acquirers
should be positive.
According to other theories mergers and acquisitions can also be value destroying. Rational
managers could pursue their own objectives and increase their own wealth at the expense of
the shareholders. Behavioral economics suggests that managers could be biased. They could
suffer from hubris, overconfidence, and/or overoptimism. These biases could lead to
overpayment or misjudge the amount of improvement they can establish when the firms are
combined.
2. What is the difference in quality between domestic and cross-border deals?
There are several arguments why cross-border deals should or should not outperform
domestic deals. Cross-border deals could outperform domestic deals because for example:
potential value added through diversification by entering a new country, the producing costs
could be lower due to lower wages, superior technology, better access to (scarce) recourses,
favourable tax conditions, and the opportunity to capture rents from foreign market
inefficiencies. There are also reasons why cross-border deals could underperform, for
example: different laws and regulations, more difficult to value a target correctly, and the
difference in culture can make it costlier to obtain value through synergies.
Second, the method of payment could influence the difference in quality. There is consensus
on the fact that cash deals outperform equity deals. Conn et al. (2005) find that cross-border
deals are more often paid with cash than domestic deals. This could be due to the fact that
cross-border targets do not have perfect information on the acquirerโs stock price and
15
therefore demand cash payment. So cross-border deals could outperform domestic deals
because of the larger stake of cash transactions.
3. Deals made during low-valuation markets are expected to have higher announcement
returns than those made during high-valuation markets.
As mentioned in paragraph 2.2 managerial herding could cause returns from deals
announced in high-valuation markets to be different from those made during low-valuation
markets. Managerial herding is associated with M&A waves and even to influence and end
waves (Bouwman et al., 2009). Managerial herding suggests that at the moment that mergers
or acquisition by early acquirers are shown to be successful, other firm want to make a
similar move. This puts more pressure on the possible synergies in takeovers made by these
late-movers. Also, the late movers could be affected by the possibility that the premium-
quality deals/targets are already picked up by the early-movers and the remaining
deals/targets are of less quality. Managerial herding suggests that merger waves tend to end at
the moment firms observe the long-term bad results from (late) acquirers. By this time many
value-destroying acquisitions are already made. Thus, managerial herding suggests that
acquirers who move late perform relatively worse compared to acquirers who move earlier.
So, according to this theory deals made during low-valuation markets are expected to have
higher announcement return than those made during high-valuation markets due to smaller
synergies and lower-quality deals during high-valuation markets relative to those made in
low-valuation markets.
4. What is the difference in quality between cross-border deals made during high-
valuation markets and those made during low-valuation markets?
There are two theories concerning the possible difference between the returns from cross-
border deals made during high-valuation markets and those made during low-valuation
markets. The first theory suggests that differences in returns are caused by the exchange rate.
The second theory suggests that differences in returns are due to managerial herding.
The first theory, which suggest that the difference between the returns from cross-
border deals made during high-valuation markets and those made during low-valuation
markets is caused by the exchange rate, is explained in two stages: first the exchange rate will
be linked to cross-border deal quality and in the second stage the exchange rate will be linked
to market valuation.
16
To link exchange rate levels to cross-border M&A performance a model developed by
Froot and Stein (1991) is used, see paragraph 2.1.1. They argue that the bidder prefers to pay
with cash because they find it costly to pay with external funds due to imperfect information
about the true value of the cross-border target. In addition Conn et al. (2005) and Gaughan
(2002) suggest that due to information asymmetry the targetโs management could demand or
force a cash bid. Next, when a bid for a foreign target is in cash, a relative strong acquirerโs
currency compared to that of the target gives the acquirer the advantage of increased
purchasing power (Markides and Ittner, 1994). This means that the acquirer can buy the
target, against a lower price, stated in his home currency. This should result in higher returns
for the bidder.
In the second stage the exchange rate will be linked to market valuation. To do this
the portfolio balance approach by Bahmani-Oskooee and Sohrabian (1992) is used. In this
model individuals allocate their wealth among domestic money and securities and foreign
money and securities. The relationship between the interest rates and the demand for money
and securities in this model is as follows: the demand for domestic (foreign) money is
inversely related to the domestic and foreign interest rate. The demand for domestic (foreign)
securities is positively (negatively) related to the domestic interest rate and negatively
(positively) to the foreign interest rate. In this model the exchange rate has to balance the
demand and supply of assets, this results in the equilibrium exchange rate.
When stock prices rise, as is the case in high-valuation states, this results in an
increase in domestic wealth. According to portfolio approach, the increased wealth will lead
to in an increase in demand for domestic money and so in an increase in domestic interest
rates. According to the model a higher domestic interest rate attracts foreign capital, which in
turn results in an appreciation of the domestic currency. This clearly shows that according to
this model there is a positive correlation between stock market levels and exchange rate
levels. (Bahmani-Oskooee and Sohrabian, 1992).
The combination of the two stages leads to the prediction that a cross-border deal
made in high-valuation markets experiences higher returns caused by a stronger currency,
due to the argument that stock market levels and exchange rate levels are positively
correlated.
The second theory suggests that differences in returns are due to managerial herding.
Managerial herding is associated with M&A waves and even to influence and end waves
(Bouwman et al., 2009). It suggests that at the moment that mergers or acquisition by early
acquirers are shown to be successful, other firm want to make a similar move. This puts more
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pressure on the possible synergies in takeovers made by these late-movers. Also, the late
movers could be affected by the possibility that the premium-quality deals/targets are already
picked up by the early-movers and the remaining deals/targets are of less quality. Managerial
herding suggests that merger waves tend to end at the moment firms observe the long-term
bad results from (late) acquirers. By this time many value-destroying acquisitions are already
made. According to this theory deals made during low-valuation markets are expected to
have higher announcement return than those made during high-valuation markets due to
smaller synergies and lower-quality deals during high-valuation markets relative to those
made in low-valuation markets. There are no reasons or evidence to assume that this
prediction changes when the sample is split between domestic and cross-border deals.
The two theories predict two different outcomes. The exchange rate theory predicts
that the cross-border deals made during high-valuation market outperform those made during
low-valuation markets. Managerial herding theory predicts the exact opposite.
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Section 4. Data
In this section the used data sample is described and which conditions it has to meet. Further,
this section will explain how the state of the market is split into high-, neutral-, and low-
periods. Last the summary statistics of the sample are covered.
4.1 Data
Data of US mergers and acquisitions is obtained from the Thomson Reuters Security Data
Corporations (SDC) Platinum US Mergers & Acquisitions Database. The obtained data has to
meet the following conditions (these follow the conditions imposed by Bouwman et al (2009)
very closely):
1) M&A was announced between 1st of January 1990 and 31st of December 2009.
2) The acquirer is a US firm listed on either the NYSE, NASDAQ or AMEX
3) The target is not a subsidiary1
4) The transaction value is at least $100 million
5) The acquirer obtains at least 50% of the shares of the target and owns less than 50%
of the targetโs shares before the acquisition.
6) The closing share price of the acquirer for the month before the announcement is at
least $3 (see Loughran and Vijh, 1997). This eliminates firms that are very small or in
distress.
7) Daily acquirer return data are available for three days around the announcement date.
After running the query, deleting outliers, and excluding observations with missing variables
the sample contains 3289 transactions.
4.2 High-, neutral-, and low-valuation markets.
This research examines the quality of M&A deals undertaken in several different market
conditions. It is therefore important to make a clear distinction between various states of the
market. This distinction can be made through P/E ratio (price to earnings ratio) from for
example the S&P 500 as used by Bouwman et al. (2009). Who, in this way, makes a
distinction between high-valuation markets and low-valuation markets. Bouwman et al. test if
the outcomes of their research differ when another method is used. Their conclusion is that is
does not matter which of their 7 suggested and tested methods is used.
1 โHansen and Lott (1996) and Fuller, Netter, and Stegemoller (2002) justify the exclusion of subsidiary
acquisitionsโ Bouwman et al (2009)
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To make this distinction in the aforementioned way the P/E ratio had to be detrended.
This is due to the fact that the P/E ratio from the S&P 500 is increasing over time. First, the
market P/E ratio is detrended by subtracting the best straight-line fit from the market P/E
ratio of the concerning month and the five years preceding this month. Next, the month is
categorized as above average if its detrended market P/E ratio is above the past five year
dentrended P/E ratio average and below if its detrended market P/E ratio is below its past five
year average. This process is repeated for every month in the sample. Last, the bottom half of
the below-average months are noted as low-valuation markets and the top half as neutral-
valuation markets. For the above-average months the top half is noted as high-valuation
markets and the bottom half as neutral-valuation markets. This results in half of the months
being neutral-valuation markets and the other half being high- and low-valuation markets
(Bouman et al., 2009).
For the sample2, January 1990 to December 2009, in this research it results in 70 high-