Do Insiders Time Management Buyouts and Freezeouts to Buy Undervalued Targets?

Jarrad Harford is Professor of Finance at the University of Washington Foster School of Business; Jared R. Stanfield is Senior Lecturer at UNSW Australia Business School; and Feng Zhang is Assistant Professor at the University of Utah. This post is based on their recent article, forthcoming in Journal of Financial Economics. Related research from the Program on Corporate Governance includes Adverse Selection and Gains to Controllers in Corporate Freezeouts by Lucian Bebchuk and Marcel Kahan.

Conflicts of interest arise in management buyouts (MBOs) and freezeouts: the acquirers (managers and controlling shareholders) have an incentive to pay the lowest price to selling shareholders, despite having a fiduciary duty to them. Such conflicts of interest could lead to unfair treatment of public shareholders. For instance, in the buyout of the Dell Inc. by its founder and CEO Michael Dell in 2013, some investors believed that “management swoops in to get a good deal right before there’s a change in the business” (Hoffman, 2016). This, and other anecdotal examples suggest that even if they plan to create value post acquisition, managers have incentives to not only negotiate lower premiums (relative to the current market price) but also to initiate deals when the firm is undervalued.

Do managers and controlling shareholders initiate MBOs and freezeouts when the target firm is undervalued? The question is difficult to answer because one cannot observe the value path of the target had it not been acquired. In our article, Do Insiders Time Management Buyouts and Freezeouts to Buy Undervalued Targets?, we circumvent this difficulty by examining the value path of the target’s industry peers following MBO and freezeout announcements.

In a sample of 470 MBOs and 518 freezeouts from 1980 to 2014, we find that a portfolio of target firms’ industry peers earns risk-adjusted abnormal returns of about 12% during the 12 months following deal announcement. In addition, the target industry’s market-to-book ratio around deal announcement is significantly below its long-term historic average. Furthermore, MBOs and freezeouts tend to occur during a trough in an industry’s performance: both return on assets and profit margin steadily decrease over the five years preceding the deal and then steadily increase over the five years thereafter. These findings indicate that the target industry is undervalued at the time of MBO and freezeout. In contrast, we find no evidence of industry undervaluation in arms-length acquisitions.

Target industry undervaluation does not necessarily mean target firm undervaluation, unless industry peers’ value path is a valid proxy for the target firm’s counterfactual path, which is a crucial assumption to our analysis. We take several steps to test the assumption. First, we find that stock returns of the target firm increase by 0.90 to 0.95 percentage points for each 1 percentage point increase in stock returns of its industry peers before MBO and freezeout announcements; and the association is highly statistically significant. We then estimate the target firms’ post-deal abnormal returns using the estimated target-peer return relation and the observed contemporaneous abnormal returns to their industry peers. We find that the target firms would also have experienced significant abnormal returns absent the acquisition. The tests indicate that value path of industry peers is a reliable proxy for that of the target firm.

Courts and regulators try to protect public shareholders in non-arm’s-length acquisitions with third-party fairness opinions, the formation of special committees of non-interested directors, and by requiring a majority approval by minority shareholders. Whereas these measures help protect public investors, our results show that they fail to prevent managers and controlling shareholders from timing the deal when the target is undervalued. The failure is not totally surprising. For example, investment bankers’ fairness opinions often use valuation multiples of industry peers to determine whether the offer price is “fair”. As a result, lower industry valuations will result in lower benchmarks and fairness opinions and thus will not constrain management or controlling shareholders who make offers during these times. In addition, managers and controlling shareholders may possess inside information about the industry, which may also facilitate deal timing.

Outside investors do not claw back the expected post-deal revaluation from management or controlling shareholder bidders through higher bid premiums or litigation. We find that MBOs and freezeouts have bid premiums similar to those of arm’s-length acquisitions; the positive post-deal abnormal returns are present in deals with both low and high bid premiums, and are present regardless of whether the deal is subsequently litigated or not.

Why do shareholders and courts not see the potential for shareholder exploitation and stop it? One possible reason lies in a statistical conundrum pointed out by DeAngelo (1986). Although target firms are on average undervalued around MBOs and freezeouts, it is difficult to convince a court of exploitation in a specific case (with a sample size of one). Consequently, exploitive deals can pool with non-exploitive ones such that exploitation can survive despite the obvious incentives and array of legal barriers to prevent it.

Our evidence is consistent with managers and controlling shareholders successfully timing their acquisition when the industry is undervalued. But, one cannot conclude that managers and controlling shareholders time buyouts and freezeouts to exploit outside shareholders. It is more difficult to establish target shareholder exploitation than deal timing: management could be merely optimistic and is lucky on average, or management and outside shareholders might have different beliefs about the prospects of the firm.

The complete article is available here.

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