Cash Windfalls and Acquisitions

Bastian von Beschwitz is a Senior Economist on the Board of Governors of the Federal Reserve System. This post is based on his recent paper.

In my paper, Cash Windfalls and Acquisitions, forthcoming in the Journal of Financial Economics, I study the effect of large exogenous cash windfalls on a firm’s acquisition activity. The cash windfalls resulted from a German tax reform that made divestitures of equity stakes tax free. Since not all firms owned equity stakes, the tax reform provided cash windfalls only to a subset of firms. I find that firms receiving a cash windfall undertake more acquisitions and that the additional acquisitions are value-destroying.

How access to financing affects a firm’s investment policy is one of the fundamental questions in corporate finance. As Stein (2003) points out, there is convincing evidence that firms with a strong financial position invest more, but it is less clear whether this effect is driven by under- or overinvestment. Underinvestment occurs if financial frictions prevent management from making value increasing investments (e.g., Myers and Majluf, 1984). In this case, it would be optimal if firms could invest more but they lack the financial resources. In contrast, overinvestment occurs if managers engage in “empire building” (Baumol, 1959; Williamson, 1964) as predicted by the free cash flow theory (Jensen, 1986). In this case, managers use excessive financing on wasteful projects that provide them with private benefits.

It is extremely difficult to determine which of these two cases is more prominent in practice, for the following two reasons. First, it is generally hard to determine whether an investment project creates value to shareholders. Second, internal financial resources and investment opportunities are typically correlated, making any simple cross-sectional study subject to endogeneity concerns. For example, firms with higher profits might invest more because they have better investment opportunities and not because the higher profits constitute additional financial resources.

In my paper, I address these issues by studying the effect of large exogenous cash windfalls on a firm’s acquisition activity. The cash windfalls resulted from the German capital gains tax reform in 2000. Before the reform, many German corporations held minority equity stakes in unrelated firms. These equity stakes often had high market values, making up a sizeable part of the holder’s assets. For example, the telecommunications and energy company VIAG owned equity stakes with a (pre-tax) market value of EUR 2.9 billion (25% of its own market capitalization) at the end of 1999. Many of these holdings had been established in the 1950s and 1960s and thus had accumulated large capital gains. Consequently, firms had strong incentives to maintain these equity stakes to avoid capital gains taxation (Sautner and Villalonga, 2010). In 2000, the German government decided to exempt the sale of equity stakes from the 50% capital gains tax, thus removing a major obstacle to the divestiture of the equity stakes. And indeed, I show that most equity stakes are divested in the following years.

Since not all firms owned equity stakes, the tax reform provided cash windfalls only to the subset of firms that owned equity stakes in 1999. This allows me to estimate the effect of the cash windfalls by comparing how firms with equity stake in 1999 changed their acquisition activity relative to firms without equity stakes after the passage of the tax reform (difference-in-difference). Crucially, I condition my analysis on the existence of an equity stake rather than the endogenous decision to divest it.

A simple comparison of means reveals that the yearly probability of doing an acquisition increases by 14% (five percentage points) for firms that hold equity stakes before the tax reform (and thus received a potential cash windfall), but decreases by 1.7 percentage points for the control group. A more elaborate difference-in-difference analysis confirms these results by showing that firms with equity stakes in 1999 increase their probability of undertaking an acquisition by eight percentage points relative to the control group. This finding confirms that firms with more cash engage in more acquisitions.

Next, I study the acquirer announcement returns to determine whether the additional acquisitions represent overinvestment or a reduction in underinvestment. Companies that owned equity stakes at the time of the tax reform experience a decrease in average announcement returns relative to the control group of 1.2 %. This finding is consistent with overinvestment.

Next, I study for which firms the results are largest. We would expect the tax reform to have a stronger effect on firms receiving larger cash windfalls. Indeed, I find that my results are largely driven by firms who rank above the median by value of their equity stakes before the tax reform. Consistent with divestitures of equity stakes providing firms with additional cash, I find that the results are concentrated in acquisitions that are paid in cash. While the probability of undertaking a cash acquisition increases by 9% for firms with equity stakes in 1999, the probability of undertaking a stock acquisition decreases slightly for these firms. Similarly, the decrease in acquisition announcement returns is concentrated in acquisitions paid for in cash. Finally, I show that the results are more prominent for firms that sold more equity stakes and that sold equity stakes with higher market values. Furthermore, I show that acquisition activity increases and announcement returns decrease in the year following the first divestiture of an equity stake.

To conclude, my results suggest that managers used the cash windfalls of the tax reform to engage in value-destroying acquisitions as predicted by the free cash flow theory.

The complete paper is available for download here.

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