A Reference Point Theory of Mergers and Acquisitions

This post comes to us from Professor Malcolm Baker and Xin Pan of Harvard University, and Jeffrey Wurgler, Research Professor of Finance at New York University.

In our recently updated working paper A Reference Point Theory of Mergers and Acquisitions, we propose a “reference point” view of mergers which holds that salient but largely irrelevant reference point stock prices of the target help to explain several aspects of mergers and acquisitions, involving both the pricing and the types and quantities of firms traded.

The standard textbook story on mergers emphasizes synergies. The offer price starts with an estimate of the increased value of the combined entity under the new corporate structure, deriving from a variety of cost reductions. This value gain is then divided between the two entities’ shareholders according to their relative bargaining power. In theory, all of this leads to an objective and specific price for the target’s shares. In practice, however, valuing a company is subjective. A large number of assumptions are needed to justify any particular valuation of the combination. In addition, relative bargaining power may not be fully established. These real-life considerations mean the appropriate target price cannot be set with precision, but established only to be within a broad range. We hypothesize that this indeterminacy, in turn, creates space for the price offered and its reception to reflect other influences, in particular the psychological influences on the board of the target and the bidder and target shareholders, who ultimately must approve the price.

The reference point stock price that we focus on is the target’s recent high. The 52-week high price is widely reported in the financial press and is salient to executives, boards, and investors. Importantly, and in contrast to target shareholders’ individual cost bases, another natural reference point, this is a reference price that is common across stakeholders. Our results show a visually and statistically obvious effect of the 52-week high. Even controlling for the target’s stock return over various fixed intervals, the 52-week high price exerts a strong positive effect on the bid price. A simple histogram of offer prices shows a spike at the 52-week high. For the modal bidder, the 52-week high serves not merely as a subtle psychological anchor but as one sufficiently heavy that there is no “adjustment” from it at all. More generally, a 10% increase in the 52-week high is associated with as much as a 3% increase in the offer premium.

Overall, we estimate that anchoring on the 52-week high leads to an arbitrary value transfer of $179 billion in the 5,135 completed mergers and acquisitions in our sample, or 18% of the total offer premium paid. We find that the probability of deal success is significantly and discontinuously increased by 3% to 4% when the bidder makes an offer price above the target’s 52-week high. We also find that the bidder’s announcement effect becomes more negative with the target’s distance from its 52-week high. Given the connection between 52-week highs and offer prices, shareholders of the bidder appear to view the bidder as more likely to be overpaying when the target has fallen far below this reference price.

The full paper is available for download here.

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