Financial vs Strategic Buyers

In our recent HBS working paper, Financial vs. Strategic Buyers, we highlight and then set out to explain the oscillating pattern of financial vs. strategic acquirers within overall merger activity. Mergers and Acquisitions occur in great waves of activity with recent troughs, for example, of only a few thousand deals in 2003 and peaks of over ten thousand deals in 1999 and 2006. Within this oscillation of activity there is another shifting pattern: the percentage of so-called financial sponsors (private equity firms) vs. strategic buyers (operating companies) seems to ebb and flow. Aggregate numbers show that the fraction of total deal value acquired by financial sponsors has varied dramatically over the last 25 years with peaks in the late 80s, 90s and the period of 2005-2007. This same pattern is true across many industries and geographies.

Any particular transaction has many factors that drive the ultimate acquirer’s willingness to pay. And many theories propose reasons why particular firms or industries may be ripe for acquisition activity. However, the broad pattern of financial sponsor activity that spans industries and geographies at a given point in time suggests a broad economic explanation for the coordination. Little research directly considers the competition between financial and strategic buyers. And almost no research offers any broad insights into the rising and falling tides of private equity activity through the different merger waves.

What drives either financial or strategic buyers to have a more dominant position in M&A activity at different points in time? This question is important not only because the economic magnitude of this activity is so large, but also because the balance of power between financial vs. strategic acquirers changes the ownership structure of assets and alters the incentives and governance mechanisms that surround the economic engine of our economy.

One potential broad economic mechanism that would imply a shifting willingness to pay by strategic investors stems directly from previous work done on merger waves. The theories of Rhodes-Kropf and Viswanathan (2004) and Shleifer and Vishny (2003) both suggest that overvalued acquirers will bid more than undervalued acquirers and overvalued targets are more willing to accept takeover offers, leading to waves of M&A activity during overvalued markets. But clearly, financial buyers who must pay in cash should avoid overvalued targets. This implies that patterns of financial vs. strategic activity could be driven by the same phenomenon. However, a quick look at the data suggests that something else must be at work as the local peaks of financial sponsor activity relative to strategic activity correspond with stock market peaks such as the late 90s and 2006-2007, with dips in the early 90s and 2001 recessions.

Harford (2005) shows that interest rates, specifically the spread between the average interest rate on commercial and industrial loans and the Federal Funds rate, are significantly inversely correlated with merger activity. Although Harford (2005) proposes no formal theory of merger activity, he argues that this spread is a proxy for overall liquidity or ease of financing. In this paper we combine the results from Harford (2005) with the ideas of the misvaluation hypothesis and explore how the possibility of misvalued debt markets can both fuel merger activity and alter the balance between PE and strategic buyers.

While it seems reasonable that if equity markets can be misvalued then so can debt markets, it is much less obvious that “cheap” debt should lead to more acquisition activity. After all, targets can also access cheap debt and so are more valuable as stand-alone entities when debt is cheap. On top of this, it is not clear how debt misvaluation should alter the interplay between financial and strategic buyers. Just believing that debt markets are overvalued does not imply a benefit to one type of buyer. After all, if both types of acquirers find a misvalued debt market, cannot both take advantage of it? Since it is not ex-ante obvious what misvalued debt might do to the M&A market or how it would differentially impact the participants, our model provides important insights and understanding. We also provide some supportive evidence of our main theoretical implications in the data to help show the strength of the theory.

While we assume that each type of buyer and the target can equally access the debt market, there exist fundamental differences that alter the benefit to each. The fundamental differences between a strategic buyer and a financial buyer are 1) strategic buyers have a current project (or projects) they are considering combining with the target, while financial sponsors evaluate the target as a stand-alone project, and 2) financial buyers have a different corporate governance structure than strategic buyers. Using these fundamental differences we consider both the co-insurance effect and the monitoring effect.

The co-insurance effect arises any time less-than-perfectly correlated projects are combined. This effect was first proposed by Lewellen (1971). We show that financial sponsors are better able to take advantage of interest rates that are too low because strategics are diversifying and therefore minimizing the error investors make. While strategics are less hurt by interest rates that are too high because diversification is highly valued when project failure rates are expected to be high. Therefore, even though both strategic and financial buyers would like to take advantage of interest rates that are “too low” and avoid borrowing when interest rates are “too high” they are differentially impacted by the errors and are willing to pay relatively more or less depending on the sign of the error made on interest rates.

There is also a monitoring effect because PE buyers are often thought to have better oversight and governance than strategics. Better monitoring causes an increase in the use of leverage. Misvaluation will also potentially alter the moral hazard problem faced by investors in the firm. In which case the governance of a financial buyer relative to a strategic buyer will potentially create another reason why financial buyers may dominate in overvalued debt markets. To the extent that PE firm oversight is a better governance structure that allows for more debt, and to the extent misvaluation makes the moral hazard problem worse, then PE buyers will be able to create more value in misvalued debt markets than strategic buyers. The joint presence of moral hazard and misvaluation yields interesting insights and allows us to contribute at a methodological level to the literature by analyzing an agency model with asymmetric information between investors and managers.

Overall, the potential for misvalued debt has a number of interesting empirical implications. First and foremost, the possibility of misvalued debt not only changes the likelihood of an acquisition, it also changes the type of buyer and the way the assets are owned. This prediction has empirical content because although the knowledge that the debt market is under or overvalued may be impossible to possess in real time, looking backward we should find that times when credit was particularly misvalued correspond to increased M&A activity and increased PE activity relative to strategic buyers. Furthermore, the level of activity of financial buyers in aggregate in the economy will correlate with default probabilities. Financial buyers will be more active and take on more debt than strategics when debt is overvalued. Thus a surprisingly large number should end up in financial distress.

We take our central prediction to the data to show some suggestive evidence on the effect of misvalued debt. We find that measures of debt market overvaluation strongly correlate with the ratio of private equity (PE) to strategic merger activity. Moreover, debt market overvaluation drives out any relationship between the PE/Strategic merger activity ratio and the high-yield credit spread. Although the limited number of waves of PE activity does not allow strong conclusions to be drawn from this data, our findings are suggestive that the theory is relevant and we hope to stimulate a more in depth look.

Second, our theory suggests that PE firms will tend to dominate strategic buyers during times when the debt markets are overvalued, but the relative dominance of PE firms to strategics should be even greater if the strategic is a conglomerate. Conglomerates are thought to have governance issues (see Scharfstein and Stein (2000) and Rajan et al. (2000)) as well as cross project co-insurance effects. Thus, the effects we propose suggest that overvalued debt markets should lead to greater dominance of financial buyers over conglomerates than over more focused strategic acquirers. We also find support for this prediction in the data.

Moreover, the model has implications for the cross section of conglomerates’ leverage. As we have just argued, in overvalued debt markets conglomerates are not able to raise as much leverage as financial buyers since co-insurance is informationally costly. On the other hand, conglomerates should do relatively more acquiring (and less divesting) during undervalued debt markets, but during undervalued debt markets leverage use will be relatively lower. Therefore, if, as in Baker and Wurgler (2002), the effects on capital structure are persistent then since more stand-alone firms with financial backers and high leverage will be created in overvalued debt markets and conglomerates will tend to make relatively more acquisitions during undervalued debt markets, conglomerates may have lower leverage on average.

Together these implications and early findings suggest that the possibility of misvalued debt may have important impacts on both firms and investors, on who buys whom, and for default levels in the economy. We hope these ideas guide future work to some interesting findings.

The full paper is available for download here.