The Real Effects of Uncertainty on Merger Activity

Robert A. Dam is Assistant Professor of Finance at University of Colorado at Boulder Leeds School of Business. This post is based on a forthcoming article by Professor Dam; Vineet Bhagwat, Assistant Professor of Finance at University of Oregon Lundquist College of Business; and Jarrad Harford, Professor of Finance at University of Washington Foster School of Business.

Imagine you are in the market for a new car. You find exactly the car you want, and agree to the price and financing conditions, but there is a twist. In this alternate universe, you can’t actually pick up your car for several months, and during this time the actual value of “your” car is likely to have changed by 20% or more. Even worse, when the car has increased in value, the dealer can back out of your agreement, while you are likely stuck with the original terms if the car’s value has dropped. Are you still ready to sign on the dotted line?

In our article, The Real Effects of Uncertainty on Merger Activity, forthcoming in the Review of Financial Studies, we suggest acquirers face a reality not unlike our hypothetical car buyer, and as a result defer acquisitions when uncertainty is high. While the bidder and target agree to the terms of the deal up front, in our sample it takes an average of 126 days until deals for publicly-traded firms are completed. During the delay, we estimate that the target’s standalone value changes by over 10% in two-thirds of the deals, and by more than 20% over half of the time. Completing our analogy, we reference earlier works in the legal literature that argue targets retain—via proxy votes and share tenders—an easy out when it suits their interests, while bidders are far more likely to be held to the deal. [1]

Although novel as a formally-tested hypothesis, it is hardly surprising then that we find substantially fewer deals get announced as uncertainty rises. When we take the VIX as a measure of forward-looking uncertainty, we find that a one-standard-deviation increase in volatility is followed by a 6% drop in deals for public firms, a $4 billion decrease in deals per month. Consistent with standard option pricing intuition, we find the effects are more pronounced when the cost of this risk to the bidder is higher. For instance, we observe stronger effects when volatility is already high, in deals for larger targets, and when the time to close risks being extended by antitrust approvals.

As the interim risk we highlight is specific to the deal rather than the broader market, we run additional tests confirming a firm-specific link between volatility and deals. A firm’s stock price volatility has an economically and statistically large adverse effect on the likelihood that it is the target of an acquisition. A one-standard-deviation increase in firm-level stock volatility reduces its likelihood of being a target by 36% (from 4.5% to 2.9%) in the subsequent year. Furthermore, we find that macro-volatility (i.e. VIX) only has an effect through its impact on firm-level volatility. A high VIX negatively affects the likelihood of takeover attempts for high-beta firms, while neither VIX nor a firm’s beta alone has any meaningful effect. Similar tests at the industry level produce comparable results: uncertainty has a large impact on deal activity, but only to the extent it impacts firm-level interim uncertainty.

To further rule out some other story linking volatility and deals, we compare these findings to a set of deals that are very similar except that both parties can ex ante commit to the agreement. Deals involving private targets or subsidiaries of public targets do not require tender windows or proxy votes, and therefore provide fewer outs for the target down the road. For these deals, we find no link between volatility and deal intensity, even after better matching the two samples on other observable characteristics. Our interim risk hypothesis therefore provides a new explanation as to why it appears that merger waves are largely a public-firm phenomenon. [2]

Our proposed link between volatility and deal activity rests squarely on the assumption that targets maintain an asymmetric right to renege on a deal when doing so suits their interests. In final tests, we therefore verify that deal renegotiations and terminations are more prevalent when the interim changes favor the target. Using observed interim industry returns as a proxy for unobserved firm value changes, we find that deals are substantially more likely to collapse when the target’s value rises. On the other hand, we see no discernible change to the likelihood a deal is completed when the target’s value drops between announcement and completion. As one-third of the initial deals in our sample fail (either get renegotiated on new terms or cancelled completely), we conclude this risk is and ought to be a first-order concern for M&A bidders.

In summary, we find a strong negative link between various measures of uncertainty and M&A deal activity. We provide evidence that the channel linking two is the asymmetric interim risk of deal failure. This risk stems from the combination of several factors: a several month delay between deal announcement and completion, material changes to firm values during this interim period, and legal limits on a bidder’s ability to back out while a target has an easier time reneging. So the next time you see deal activity drop as the markets start to churn, just be glad you aren’t buying a car under these conditions.

The full article is available for download here.


[1] For discussions of the limits on a bidder’s right to back out of an M&A deal, see Fraidin and Hansen (1994), Gilson and Schwartz (2005), and Somogie (2009).
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[2] Both Netter, Stegemoller and Wintoki (2011) and Maksimovic, Phillips and Yang (2013) note that the wave-like pattern of merger activity for public targets is largely absent in the market for private firms.
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