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E-MailLucian Taylor is Assistant Professor of Finance at the University of Pennsylvania. This post is based on an article authored by Professor Taylor; Di Li, Assistant Professor of Finance at Georgia State University; and Wenyu Wang, Assistant Professor of Finance at Indiana University.
The main goal of our paper, Inefficiencies and Externalities from Opportunistic Acquirers, which was recently made publicly available on SSRN, is to quantify a potential inefficiency in the mergers and acquisitions (M&A) market. If a firm believes its shares are overvalued, then it has an incentive to acquire other companies and pay using its overvalued shares rather than cash. This behavior creates an inefficiency: Overvalued, opportunistic acquirers may crowd out other acquirers that have higher synergies. The inefficiency, in other words, is a lost synergy. Researchers have raised concerns about this inefficiency, but it remains unclear whether the inefficiency is large or small. Our main contribution is to show that the aggregate inefficiency from opportunistic acquirers is actually quite modest, meaning the M&A market usually allocates resources efficiently. We do find, however, that the inefficiency is large for certain deals and during times when misvaluation is more likely. We also show that misvaluation results in a large wealth transfer from undervalued to overvalued acquirers, and it makes access to cash valuable for synergistic acquirers.
Our empirical methodology is structural estimation, which is an attempt to fit an economic model to the data, assess how well the model fits the data, and measure fundamental economic parameters. This methodology is common in certain fields of economics, such as industrial organization, and it is becoming more popular in corporate finance.
We estimate a structural model in which two acquirers compete in an auction to buy a target firm. All firms in the model are rational and maximize expected profits. The target firm is confused, however, because it cannot perfectly observe the acquirer’s synergy, the misvaluation of the acquirer’s shares, or the acquirer’s access to cash as a means of payment. This confusion allows overvalued acquirers to camouflage themselves and submit bids that appear more attractive to the target than they truly are. As a result, an overvalued, opportunistic acquirer with a low synergy will sometimes win the auction, inefficiently crowding out a high-synergy acquirer.
We estimate the model using data on 2,771 U.S. M&A contests involving public acquirers and targets from 1980 to 2013. The model can closely fit the distribution of offer premia and cash versus equity payment, as well as their relation to deal size. The model also closely fits the relation between bidders’ announcement returns and their chosen method of payment.
Once we have estimated the model, we can use it to quantify the inefficiency from opportunistic acquirers. We find that an overvalued bidder crowds out a bidder with a higher synergy in 7.9% of deals. These deals are inefficient in the sense that the high-synergy bidder would always win in an ideal world with no misvaluation. In the 7.9% of deals that are inefficient, the average synergy lost is 11.8% of the target’s pre-acquisition value. Averaging across all deals (efficient and inefficient), the aggregate synergy loss is just 0.9% of the target’s pre-acquisition value, which translates to $6.5 billion in lost synergies for U.S. deals in 2014. The main reason we find a small efficiency loss is that the difference across competing acquirers’ synergies is usually much larger than the difference in their shares’ misvaluation. As a result, high-synergy acquirers out-bid overvalued acquirers about 92% of the time, producing efficient deals.
While the inefficiency is quite low on average, it is very large in certain deals. For example, at the 90th percentile among inefficient deals, the synergy loss is 27% of the target’s pre-acquisition value. Also, we find that the efficiency loss is more than 60% higher in time periods when misvaluation is more likely in aggregate, for example, when investor sentiment or stock-market volatility is high. The estimated inefficiency is similar in magnitude across firms with weak versus strong governance.
Next, we measure how misvaluation affects the distribution of merger gains across acquirers. Misvaluation helps overvalued acquirers by allowing them to use their shares as a cheap currency. Misvaluation hurts undervalued acquirers, because even when they do manage to win the M&A contest, they often end up paying higher prices due to competing, inflated bids. In other words, overvalued acquirers impose a negative externality on other acquirers. We find that the average wealth redistributed from undervalued to overvalued acquirers is very large: 7.1% of the target’s pre-acquisition value, which translates to roughly $50 billion of wealth redistributed per year among U.S. public acquirers.
Undervalued acquirers can avoid these adverse effects by paying for acquisitions in cash rather than shares. Access to cash is therefore valuable. We use the estimated model to measure the value of extra cash capacity. On average across all deals, we find that one extra dollar of cash capacity increases a bidder’s merger gain by 2.7 cents. The marginal value is larger for undervalued bidders, since they have no desire to pay using shares, and also for bidders with little cash capacity. For a severely undervalued bidder (5th percentile) with zero cash capacity, an additional dollar of cash capacity can increase its merger gain by 12 cents when the deal synergy is high. These results highlight one way that financing constraints harm firms: Financing constraints force undervalued firms to make acquisitions using shares rather than cash, which makes them pay more and increases their chances of being crowded out.
To summarize, we find that the aggregate inefficiency from opportunistic acquirers is small on average, but it is large in certain deals and in times when misvaluation is more likely. We also measure an externality that overvalued bidders impose on synergistic bidders: By pushing up acquisition prices, overvalued bidders reduce undervalued bidders’ merger gains. Undervalued bidders can avoid these externalities by paying in cash rather than shares, which makes access to cash more valuable. Overall, our paper shows that corporate financing has important effects on real economic efficiency.
The full paper is available for download here.
