Merger Momentum and Investor Sentiment: The Stock Market Reaction to Merger Announcements ...

372 Pages·2016·13.71 MB·English

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Merger Momentum and Investor Sentiment: The Stock Market Reaction to Merger
Announcements
Author(s): Richard J. Rosen
Source: The Journal of Business, Vol. 79, No. 2 (March 2006), pp. 987-1017
Published by: The University of Chicago Press
Stable URL: http://www.jstor.org/stable/10.1086/499146
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The Journal of Business
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Richard J. Rosen
FederalReserveBankofChicago
Merger Momentum and Investor
Sentiment: The Stock Market
Reaction to Merger
Announcements*
I. Introduction This paper examinesthe
effectsof mergerson
I examine whether the market reaction to a merger bidding firms’ stock
announcement depends on the recent merger history prices. I find evidenceof
of the overall market and of the bidding firm. There mergermomentum: bid-
der stock pricesaremore
hasbeenagreatdealofattentionpaidtowhenmergers
likely to increasewhen a
occur.Forexample,Nelson(1959)documentsmerger
mergeris announcedif
waves dating back to the period 1898–1902, and recentmergersby other
Holmstrom and Kaplan (2001), among others, de- firms have been received
scribe the merger waves in the 1980s and 1990s. well (a “hot” merger
market)or if the overall
Less attention has been paid to comparing cycles
stock marketis doing
in the quality of mergers. Variations in merger qual-
better. However,thereis
ity—which are gauged using the return to bidding long-run reversal.Long-
firms—overamergercyclecanshedlightondifferent run bidder stock returns
theories on why and when acquisitions occur.1 This are lowerfor mergersan-
nounced when eitherthe
study examines whether market factors influence the
mergeror stock markets
reactiontoamergerannouncement.Ishowthatthere
werehot at the time of
isaformofmomentuminmergers;thatis,themarket the mergerthan for those
reaction to a merger is positively correlated with the announced at other times.
response to other mergers in the recent past.
Theliteratureevaluatesamergeronthebasisofthe
*Theopinionsexpresseddonotnecessarilyreflectthoseofthe
FederalReserveBankofChicagooritsstaff.Thankstoananon-
ymousreferee,DariusMiller,TerryNixon,XiaoyunYu,AmyDitt-
mar,andtheparticipantsinalunchtimeworkshopatIndianaUni-
versityandtheMergerRoundtableattheFederalReserveBankof
[email protected].
1.The return to a bidding firm reflects both the quality of the
merger and the price paid by the bidder for the target. I discuss
thisinthenextsection.
[JournalofBusiness,2006,vol.79,no.2]
(cid:1)2006byTheUniversityofChicago.Allrightsreserved.
0021-9398/2006/7902-0020$10.00
987
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988 JournalofBusiness
initialmarketreactiontothemergerannouncement(e.g.,Asquith,Bruner,and
Mullins 1983) and on the long-run returns to the merger(e.g.,Loughranand
Vijh 1997). To understand the sources of merger momentum, I compare the
announcementreactiontothelong-runreturn.Iuseacross-sectionalanalysis
of6,259completedacquisitionsbypublicfirmsannouncedbetween1982and
2001 to determine the factors that affect the relationship between the an-
nouncement reaction and the long-run return.
I examine three different theories that are each consistent with merger
momentum but have different predictions about long-run returns. The neo-
classicaltheoryofmergersassumesthatmanagersacttomaximizeshareholder
value. Under this theory, merger momentum may result from shocks that
increasesynergiesforagroupofmergers.Mergersannouncedfollowingthese
shocksshouldbebetter,onaverage,thanothermergers,leadingtocorrelated
announcement returns. A second theory is that there are managerial moti-
vations for mergers. If managerial objectives drive merger decisions, then
acquisitions during waves may be worse than other mergers (Gorton, Kahl,
and Rosen 2005). Under either theory, rational shareholders are assumed to
react immediately to the new information contained in a merger announce-
ment. Thus there should be no long-run drift after the announcement, or, at
a minimum, there is no reason that the postacquisition returns to a bidder’s
stock should depend on when the merger announcement occurs.
ThethirdtheoryIexamineisthatmomentumresultsfromoverlyoptimistic
beliefs on the part of investors and possibly managers. A recent literature
suggeststhatshareholderreactiontoacorporateannouncementcanbeaffected
by investor sentiment, that is, the reaction of investors to factors other than
the value created by the merger (e.g., Helwege and Liang [1996] for initial
public offerings [IPOs]). Merger momentum could result frominvestorsasa
groupbecomingoptimisticaboutmergersannouncedduringaparticularperiod
of time.
If the market reaction to merger announcement isnotbasedonfundamen-
tals, it might also affect merger decisions. Mergers are more frequent when
the bidders appear to be overvalued (Dong et al. 2003; Rhodes-Kropf, Rob-
inson, and Vishanathan 2005; Shleifer and Vishny 2003). If valuations are
driven by beliefs, it is possible that managers may make more acquisitions,
especially those financed using stock, during periods of optimism because
theyoffergoodopportunitiestoissuelargeamountsofstockatanovervalued
price.2Notethatmanagersalsomaymakeadditionalacquisitionsduringthese
times if they are imbued with the same optimistic beliefs as investors.
When swings in merger momentum are caused by changes in optimism,
anyincreaseinabidder’sstockpriceshouldreverseinthelongrunasbeliefs
are replaced by results. If managers make worse acquisitions in hot markets
2.Thereisnoreasontobelievethat,duringhotmarkets,stockissuedtopurchasecapitalgoods
willbelessovervaluedthanstockissuedtofinancea merger,allelseequal.However,itmay
be difficult to find a worthwhile capital project that involves as much expenditure as a major
acquisition.Thatis,mergersareanefficientwaytomakelargecapitalpurchaseswithstock.
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MergerMomentumandInvestorSentiment 989
(becausetheypursueprivatebenefitsorbecausetheyoptimisticallyovervalue
targetfirms),thenthelong-runreturntobiddersmightbenegativeevenwith
a positive announcement return included.
Usingalargesampleofacquisitions,Ifindevidenceofmergermomentum.
The market reaction to a merger announcement is positively related to the
reactiontootherrecentmergerannouncements.However,theeffectsofmerger
momentumdisappearinthelongrun.Firmsannouncinganacquisitionduring
a hot merger market perform no better and possibly worse, all else equal,
thanthoseannouncingatothertimesdo.Thisisconsistentwithoveroptimism
in hot merger markets. It also suggests that managerial motivations may in-
fluence merger decisions in hot markets.
Momentum exists in other forms. I show that there is some evidence of
merger momentum at the firm level. There is also momentum in thebroader
stock market that carries over to merger markets.
Thepaperisorganizedasfollows.SectionIIpresentshypothesesbasedon
thepreviousliterature.ThedataandempiricalmodelarediscussedinSection
III. The short-run marketreactionstomergerannouncementsareanalyzedin
Section IV. Section V examines the long-run market response to merger an-
nouncements. Section VI offers some conclusions.
II. Merger Momentum
I define merger momentum as a correlation between themarketreactiontoa
mergerannouncementandrecentmarketconditions.Thusahotmergermarket
is one in which the reaction to recent market conditions has been favorable.
Hot markets are related to, but not necessarily the same as, merger waves.
Waves are traditionally measured by thenumber(orvalue)ofmergersrather
than by the market’sreactiontomergerannouncements.Themarketreaction
depends on the new information contained in a merger announcement (e.g.,
whether a merger is likely to create synergies) as well as how the market
reacts to that information. In this section, I describe possible origins of mo-
mentum and discuss the hypotheses tested in the following sections.
Mergermomentumcanreflectcommonfactorsthatinfluencethesynergies
available from different mergers. Studies suggest that mergers are clustered
around economic and regulatory shocks (Mitchell and Mulherin 1996; An-
drade,Mitchell,andStafford2001).Giventhatmostmergersoccurfollowing
shocks and there is evidence of a positive stock market reaction to mergers
(e.g., Andrade et al.), it is possiblethat theshockscreatecommonsynergies.
Theneoclassicaltheoryofmergersimpliesthatfirms—actingintheinterests
of shareholders—make only acquisitions that increasetheirvalue.Ifmergers
are concentrated around common shocks that positively affect the potential
synergies from all mergers, then mergers following shocks should be better
than other mergers. To put it another way, mergers during waves should, on
average, have higher synergies than mergers at other times. Thus, while the
number of mergers and the market reaction to merger announcements need
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990 JournalofBusiness
not be related, if the neoclassical theory holds and if merger waves are re-
sponsestocommonshocks,thenmergerwavesandmergermomentumshould
be highly correlated.
Managerial motivations, possibly in reaction to shocks, can also lead to
increases in merger activity. If making an acquisitionreducestheprobability
thatafirmissubsequentlyacquired,thenmanagerscanusemergerstopreserve
privatebenefits(Morck,Shleifer,andVishny1990).Gortonetal.(2005)show
that merger waves can arise when managersmakeacquisitionstodeterother
firms from acquiring their firms (“eat or be eaten”). A manager is willing to
acquire defensively even when it is not profitable. Gorton et al. show that
defensive merger waves can result from economic shocks. If mergersduring
waves are more likely to be defensive in nature, then these mergers should
be less likely to create value. So, bad acquisitions can clump in time, and at
least in the long run, mergers during waves should be worse than other
mergers.
The market reaction to a merger announcement by the shareholdersofthe
biddingfirmdependsonmorethanjustthepotentialsynergiesfromthemerger.
It also depends on whether the managers of bidding firm are able to capture
some of the synergies for their shareholders, whether the market anticipates
the acquisition, and whether shareholders react rationally to merger an-
nouncements. Throughout the remainder of the paper, I assume that bidding
firm managers get at least a portion of any surplus and that mergers are not
fullyanticipatedbythemarket.Iftheseconditionsdonothold,thenweshould
see no relationship between hot merger markets and merger announcement
returns.
Ifshareholdersarerational,giventhemaintainedhypotheses,boththeneo-
classical theory andmanagerialmotivationsgeneratemergermomentum,but
of a different sort. Under the neoclassical theory, we should see a positive
correlation between merger waves and the market reaction to a merger an-
nouncement, whereas if managerial motivations dominate, the correlation
couldbenegative.Sincethemarketreactioncontainsalltheinformationabout
the future prospects of the soon-to-be-combined firms, there is no reason to
expect the price change to reverse after the merger is completed.
Mergermomentumcanalsooccurifinvestorssystemicallymisperceivethe
synergies available from mergers. There is evidence that investors may be
overlyoptimisticinso-calledhotmarkets.LoughranandRitter(1995)attribute
high returns on seasoned equity offerings to optimistic beliefs on the part of
investors.Ljungqvist,Nanda,andSingh(2002)modelandHelwegeandLiang
(1996) find evidence of overoptimism in hot IPO markets. Loughran, Ritter,
and Ryndqvist (1994) suggest that IPO issuers time their issues to take ad-
vantage of the optimism of investors in hot markets,implyingthattheissues
inhotmarketsmaybeworsethanaverage.Thesamephenomenoncouldexist
in hot merger markets. If overoptimism influences the market reaction to
merger announcements, then we should see autocorrelation in the returns to
biddingfirmsfrommergerannouncements.Duringhotmergermarkets,when
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MergerMomentumandInvestorSentiment 991
optimism reigns, the market reaction to all announcements should be more
positive than at other times. However, price increases should reverse in the
long run as optimism is replaced by results.
Investor sentiment can also affect the type of acquisitions firms make.
Managers may be imbued with the same optimism as investors during hot
markets. If so, then they might overestimate the synergies from a merger,
leading them to make more (ex post) bad acquisitions during hot markets.
Alternatively,managersmayusehotmarketsascovertoexploitshareholders.
If managers are rewarded for increasing stock prices, then they have an in-
centivetomakebadacquisitionsinhotmarkets,sinceevenabadacquisition
may temporarily boost the acquirer’s stock price. When this managerialmo-
tivation is important enough, mergers made in hot markets would be worse
than those made in cold markets.
There is also evidence that mergers occur when the overall stock market
ishot.Nelson(1959)andJovanovicandRousseau(2001)findanassociation
betweenaggregatestockpricesandmergers(althoughtheevidenceonwhether
stockpricechangescausechangesinthenumberofmergersismixed[Weston,
Chung, and Siu 1998]). Nelson finds that merger waves starting in the late
1800sareassociatedwithstockmarketbooms.JovanovicandRousseaushow
that this correlation persiststhrough 2000. Both studiessuggestthatmanyof
the merger waves were caused by changes in the business environment that
both increased overall stock prices and led to more profitable mergeroppor-
tunities. The correlation between aggregate stock prices and mergers could
providesupportfortheneoclassicaltheoryofmergersifarisingstockmarket
reflects an increase in potential merger synergies. In this case (if our other
maintained hypotheses hold), mergers during hot stock markets should be
better for bidding firm shareholders than mergers at other times.Thisshould
be reflected in stock price increases upon a merger announcement with no
reversal, on average, in the long run.
There may also be nonfundamentalreasonsforanassociationbetweenhot
stock marketsand mergers. Firmsaremorelikelytomakeacquisitionswhen
theirstockpricesareovervalued(Dongetal.2003;Rhodes-Kropfetal.2005).
If hot stock markets mean that more firms have overvalued stock, then this
could lead to a correlation between hot markets and mergers. In this case, a
rationalstockmarketwouldreacttoamergerannouncementasevidencethat
a firm may think its stock is overvalued. This would lead to a negative
announcement reaction with no long-run drift.
Of course, the correlation between mergers and stock prices could reflect
overoptimism. In this case, weshouldseeamorepositivereactiontomerger
announcements during hot stock markets, but this should reverse in thelong
run.
The three theories of why firms make acquisitions offer different expla-
nations of merger momentum and how hot markets and mergers might be
associated. If mergers come from either synergies or overoptimism, thenthe
market reaction to a merger announcement should be more positive during
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992 JournalofBusiness
hot markets. Since both synergies and overoptimism can occur on a market-
wide basis, both theories explain hot merger markets. However, the theories
differ in their long-run predictions. If mergers are made toexploitsynergies,
then they should add to firm value in the long run; if optimistic investor
sentiment drives the reaction to mergers, then the long-run performanceofa
bidding firm should be no better than without the merger. Overlaid on these
theories is the fact that merger decisions are made by managers who may
have private interests. If managershave greaterincentivestomakedefensive
acquisitions in hot markets, then this should contribute to further weak per-
formance for mergers at these times.
III. Model and Sample Development
This section sets out the data sample and the model to be tested.
A. Data
I look at mergers and acquisitions by U.S. firms announced between 1982
and2001asgivenintheSecuritiesDataCorporation(SDC)database.Idefine
amergerasanacquisitionofequityinwhichonefirmpurchasesatleast50%
ofanotherand,afterthepurchase,thebidderownsatleast90%ofthetarget.
Thus I do not include gradual acquisitions, in which a bidder establishes a
toehold and then slowly increases its ownership until it takesovercontrolof
the target.
IusetheannouncementdatesreportedintheSDCdata.3Stockmarketdata
are collected from the Center for Research in Security Prices (CRSP) data
set, and balance sheet and income data come from Compustat. I drop any
mergers in which I cannot get CRSP and Compustat data for the bidder.
In order to focus as tightly as possible on the effect of general market
conditions, I make a number of cuts to the sample. First, tender offers are
notincludedinthebasicsample.Acquisitionscanbemadeviaeitheramerger
or a tender offer. Mergers are generally friendly agreements between the
management of the bidding and target firms, whereas tender offers involve
thepurchaseofshareswithouttheneedforapprovalfromtargetmanagement.4
I exclude tender offers for two reasons. First, studies generally find that the
market response to tender offers is more positive (or less negative) than the
reactiontomergersoverbothshort-termandlong-termhorizons.5Inpart,this
maybeduetotheprevalenceofcashpaymentsintenderoffers(Martin1996).
If the proportion of tender offers is related to market conditions, we could
3.Fuller,Netter,andStegemoller(2002)findthattheSDCannouncementdateiswithintwo
daysoftheannouncementdatefoundbyasearchofothersourcesforeachofthe500mergers
theyexamined.
4.Somemergersmaystartwithhostileoffersthat,afternegotiations,endupwithafriendly
mergeragreement.Also,sometenderoffersmayhavetheapprovalofthetargetboardofdirectors.
5.SeeJensenandRuback(1983)forasurveyoftheshort-runresponseliteratureandLoughran
andVijh(1997)forarepresentativelong-runresponsestudy.
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MergerMomentumandInvestorSentiment 993
attribute some results to market conditions rather than to the mix of tender
offers and mergers. The second reason is that there are no tender offers for
private firms or for subsidiaries. Thus, totheextentthattherearedifferences
in the market response to acquisitions of public targets, private targets, and
subsidiaries (Fuller et al. 2002), the inclusion of tender offers can bias our
results. For these reasons, and since only a small proportion of acquisitions
are tender offers, I focus on mergers only. All the results are robust to the
inclusion of tender offers (see below).
Many of the mergers in the SDC database involve a target that is much
smaller than the bidding firm. It is unlikely that such an acquisition would
have a material effect on thefutureearningsofthebidder,andthusitshould
have little effect on the bidder’s stock price. To concentrate on the mergers
most likely to have a significant effect on the bidding firm’s stock price, I
requirethatthetargetbeatleast10%ofthebidder’ssize.Itisimportantthat
wehavearelativesizecutoff,buttheexactminimumtargetsizeislesscrucial.
The main results hold for any cutoff between 5% and 25%.
To measure the relative size of the target and the bidder, I calculate the
ratio of the market value of the target to the market value of the bidder. If I
cannotfindamarketvalueforthetarget(mosttargetsarenotpubliclytraded),
I use the price paid in the acquisition as a proxy for it. When I cannot find
the price paid in the acquisition, I use the book values of equity for boththe
target and the bidder to estimate relative size. I also eliminate mergers in
whichthetargetismuchlargerthanthebidder.Thesemergersarenotcommon
and may reflect special circumstances. So, I drop any merger in which the
target is more than 120% of the size of the bidder.
Finally,Ieliminateoutliers.Anyfirmwithanegativebookvalueofequity
or with a ratio of the book value of equity to the market value of equity of
over 10 is dropped. I also exclude firms with a return on assets of below
(cid:1)100% or above 200%. Once I have done this, I also drop mergers in the
top 1% and the bottom 1% of the abnormal announcement return.
Iamleftwithasampleof6,259mergers.Table1providessomedescriptive
statics on the sample. I discuss the table when I introduce the variables.
B. Empirical Model
Theempiricalmodelissetuptotesthowrecentmergeractivityandchanges
in stock prices affect the market reaction to a merger announcement in both
the short run and the long run. I focus on the bidding firm only. This allows
me to include acquisitions of private firms and subsidiaries. To test market
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TABLE1 SummaryStatistics
Standard
Variable Mean Median Deviation
Trailing12-monthaverageCAAR 1.95% 2.11% 1.04%
Trailing12-monthnumberof
mergers 450 495 209
Trailing12-monthreturnonthe
CRSPvalue-weightedindex 17.40% 18.48% 14.61%
CAARonthelastannouncementby
thefirm 2.03% .49% 8.24%
Dummythatis1ifthisisthefirst
announcementbythebidderin
theprior3years 67.41% 1 46.88%
Numberofmergersbythebidderin
the3yearspriortothe
announcement .52 1 .97
Trailing12-monthBHARonthe
bidder’sstock 11.17% (cid:1).69% 70.36%
Stockfinancing 25.20% 0 43.42%
Otherfinancing 74.80% 1 43.42%
Targetispublicfirm 23.15% 0 42.18%
Targetisprivatefirm 43.19% 0 49.54%
Targetissubsidiary 33.66% 0 47.26%
Totalassetsofbiddingfirm($
millions) 2,327.32 197.71 13,572.86
Log(biddertotalassets) 8.35 8.30 .88
Ratiooftarget-to-biddersize 32.72% 23.47% 24.37%
Bidderbook-to-market .61 .50 .53
BidderROA 1.30% 3.09% 13.79%
Diversifyingmerger 15.50% 0 36.19%
Note.—Summarystatisticsforthesampleof6,259mergersannouncedduring1982–2001.Trailing12-
month number of mergers is the number of sample mergersin the 12 months priortoanannouncement.
Trailing12-monthaveragecumulativeabnormalannouncementreturn(CAAR)istheaverageCAARforall
samplemergersinthe12monthsendingthreedaysbeforeanannouncement.CAARforthelastannouncement
bythefirmisforthemostrecentmergerinwhichthetargetisatleast10%thesizeofthebidderaslongas
themergerwasannouncedinthethreeyearspriortothecurrentannouncement.Thebuyandholdreturn
(BHAR)ismeasuredrelativetotheCRSPvalue-weightedindex.Theratiooftarget-to-biddersizeistheratio
oftargetequitytobidderequity.Stockfinancingisthepercentageofmergersthatareentirelyfinancedby
stock.Otherfinancingisthepercentageofmergersthathavesomenonstockfinancing.Targetispublic,private,
andsubsidiaryrefertothepercentageofmergerswiththattypeoftarget.Bidderbook-to-marketisthebook-
to-marketequityratioandreturnonassets(ROA)isthereturnofassets,bothmeasuredattheendoftheyear
priortothemergerannouncement(usingthenetincomefortheentireyearinROA).Diversifyingmergeris
thepercentageofmergersinwhichthetargetandthebiddingfirmareindifferentindustries.Iusethe17-
industry classification available at http://www.mba.tuck.dartmouth.edu/pages/faculty/ken.french/data
_library.html.
reaction, I control for the financial health of the bidder and the specificcon-
ditions of the acquisition. The basic model is
market reactionpf(merger activity, market momentum,
bidder-specific merger activity,
bidder-specific stock momentum, deal-specific
and bidder control variables). (1)
The dependent variable in the model, the market reaction to a merger, is
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MergerMomentumandInvestorSentiment 995
measured over two horizons. In the next section, I examine the short-run
market reaction to a merger announcement using the five-day cumulative
abnormalannouncementreturn(CAAR)forthebiddingfirmsurroundingthe
first public mention that a merger is being discussed or proposed (days (cid:1)2
through (cid:2)2).6 This gives the immediate reaction to the merger. The price
reactionincorporatesanynewinformation,includingsynergiescreatedbythe
mergerandthesplitofsynergiesbetweenbidderandtarget,butitalsoincludes
the effect of investor sentiments such as overoptimism. Section V examines
the long-run reaction to a merger announcement. If the short-run response
contains all the information about a merger, thepostannouncementabnormal
return should be zero on average. Any systematic patterns in the postan-
nouncement abnormal return may be due to investor sentiment. Idiscussthe
proxies for the short- and long-run marketreactionsinthenexttwosections,
respectively. The remainder of this section describes the key right-hand-side
variables in (1).
The reaction to a merger announcement may depend on recent mergers. I
include two measures of recentoverall mergeractivity,onetocapturewaves
andonetocapturemergermomentum.ShughartandTollison(1984)findthat
there is autocorrelation in merger activity, with the number of mergers in a
yearhelpingpredictthenumberofmergersinthenextyear.Sincethefactors
thatleadtoanautocorrelationinthenumberofmergersmightalsoaffectthe
marketreactiontothemergerannouncements,Iincludethenumberofmergers
in the year prior to a particular announcement as one measure of merger
conditions.7 There is an average of 450 mergers in the year prior to the
announcements made during the sample period, but the number of mergers
is much larger in the latter part of the sample period (see fig. 1).
The second measure of recent merger conditions is the main measure of
hotmergermarkets.Imeasuremergermomentumusingtheaveragefive-day
CAAR on merger announcements made in the 12 months prior to an an-
nouncement. I estimate the CAAR using the market model.8 A hotmarketis
one in which recent mergers have generated strong announcement returns.
The two measures of merger activity are positively correlated, but there
are differences (see fig. 1). The number of mergers has a local peak in the
1980s, but it is much higher in the 1990s than in the earlier decade. This
measure identifies the late 1990s as a hot market relative to the rest of the
sample period. It thus misses the merger wave in the 1980s. The number of
mergersin the1980swashighbyhistoricalstandards,butnotincomparison
6.The results are similar using a three-day window. I choose the five-day windowbecause
Fulleretal.(2002)findthatafive-daywindowaroundthemergerannouncementdategivenby
SDCis wide enough to capture the firstmentionofamergereverytimefora sampleof 500
announcements.Also,notethatifmergerdiscussionsarebrokenoffbutlaterresumed,Ichoose
theannouncementthatdiscussionsarebeingresumedastheannouncementdate.
7.Iincludeonlymergersinwhichtheratiooftargetsizetobiddersizeisatleast10%and
nomorethan120%.Seethediscussionintheprevioussection.
8.TheresultsarerobusttoothermeasuresofCAARsuchastheonesdescribedinthenext
section.
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