Political Uncertainty and Cross-Border Acquisitions

Chunfang Cao is an associate professor of accounting at the Business School, Sun Yat-sen University; Xiaoyang Li is an associate professor of finance at the Shanghai Advanced Institute of Finance (SAIF), Shanghai Jiao Tong University; and Guilin Liu is with Huatai Property & Casualty Insurance Co., Ltd. This post is based on their recent article, forthcoming in the Review of Finance.

Cross-border acquisitions have become increasingly popular as more firms expand their businesses across national borders. Yet, politicians frequently make decisions that alter the environment in which firms operate, which creates a significant amount of uncertainty for acquisition decisions. Business executives often cite uncertainty as a major threat to investments and growth. Considering the rising importance of cross-border acquisitions and executives’ concerns over heightened political uncertainty, the authors investigate how political uncertainty affects such decisions.

Unlike domestic investment, cross-border acquisitions are exposed to political uncertainty in both acquirer and target countries. The authors first investigate whether the volume of inbound foreign acquisitions is associated with the target country’s level of political uncertainty. Target country political uncertainty can affect inbound foreign acquisitions through changes in regulatory regime, fiscal and taxation policies, and in some extreme cases, expropriation or nationalization of foreign-owned assets. Fear of expropriation is among the most cited causes for companies to scale back, delay, or cancel investment in foreign countries. Recent national elections in many countries, including the U.S., highlight the popularity of protectionism, nationalism, and in some cases, xenophobia, which can deter potential foreign buyers.

Cross-border acquisitions are also exposed to the acquirer country’s political uncertainty. Firms become cautious and reduce spending when facing uncertainty, especially for cross-border acquisitions which tend to be large and risky investments. As such, potential acquirers will delay cross-border acquisitions until home country political uncertainty resolves itself. Although delaying acquisitions can exempt potential investments from political uncertainty, a firm cannot timely exploit market opportunities because of such lags. Moreover, conventional wisdom posits that it is better not to “put all of your eggs in one basket.” Therefore, geographic diversification through cross-border acquisition can reduce risks. Accordingly, potential acquirers can explore cross-border acquisitions to hedge risks stemming from political uncertainty in the home country. The authors formulate a hedging hypothesis for acquirer country political uncertainty.

The authors use timing of national elections to proxy for political uncertainty in a cross-country setting. Election timing is a broad measure of political uncertainty, capturing not only possible changes in specific government policy, but also changes in government leadership. National elections are accompanied by significantly increased political uncertainty, which is largely outside of firms’ control. Empirically, most national elections take place at pre-determined points in time and different countries have different election times, generating great variation in political uncertainty across countries and over time. Thus, elections around the world provide a quasi-natural experiment framework to study the effects of policy uncertainty on cross-border acquisitions.

Using national elections in 47 countries between 2001 and 2013 as sources of exogenous variation in political uncertainty, the authors find strong evidence that political uncertainty affects the volume, characteristics, and outcomes of cross-border acquisitions. The volume of inbound cross-border deals declines significantly in the year prior to a target country national election. In contrast, the volume of outbound cross-border acquisitions increases significantly in the year prior to an acquirer country national election.

Fear of expropriation is an important consideration in deterring foreign acquirers from investing in a country with an upcoming election. The authors construct three variables to measure a country’s expropriation risk. The first variable employs historical information regarding a country’s expropriation incidents. The second variable is based on assessment of risk of “outright confiscation” and “forced nationalization” by the International Country Risk Guide (ICRG). The third variable is the strength of checks and balances which measure judicial restraints to protect private property from executive branch seizure. With these three measures, the authors show that the volume of inbound foreign acquisitions drops significantly prior to national elections in countries with greater expropriation risk. These results suggest that fear of expropriation is an important channel through which a target country’s election deters inbound foreign acquisitions.

The home co­untry election’s encouraging effect on outbound cross-border acquisitions implies that cross-border acquisitions can help hedge against some of the home country political risks. The authors conjecture that acquirers will favor target countries that have lower political uncertainty or countries that can offset some of the home country political uncertainty. The findings are supportive. First, the number of cross-border acquisitions drops significantly in years when both countries have upcoming national elections. This result suggests that when firms explore cross-border acquisitions to hedge against home country political uncertainty, they avoid target countries with forthcoming elections. Second, prior to home country elections, acquirer favor target countries with free trade agreements (FTAs) or military alliances. Third, outbound cross-border acquirers are more likely to choose destination countries with better governance quality, especially countries with better shareholder protection and institutional quality.

At transaction level, the authors show that stock market reactions to cross-border deals incorporate political uncertainty considerations. In particular, the announcement returns to acquiring firms are lower in the target country’s pre-election years. In contrast, outbound cross-border acquisitions before acquirer country political elections yield greater announcement returns to the acquiring firms. Acquirers are more likely to include acquirer termination fee clauses in the agreement prior to acquirer country national elections. Acquirers are more likely to withdraw a cross-border deal in the year leading up to either acquirer or target country elections. These results are consistent with the hypothesis that firms adjust deal terms and structures to partially hedge against the potential risk due to political uncertainty when negotiating deals.

Overall, the macro and micro-level results shed new light on the effects of political uncertainty by providing evidence through cross-border acquisition channels.

The complete article is available for download here.

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