Institutional Trading around M&A Announcements

Eliezer Fich is Professor of Finance at Drexel University LeBow College of Business; Viktoriya Lantushenko is Assistant Professor of Finance at Saint Joseph’s University; and Clemens Sialm is a Professor of Finance and Economics at the University of Texas at Austin McCombs School of Business. This post is based on their recent paper.

Related research from the Program on Corporate Governance includes M&A Contracts: Purposes, Types, Regulation, and Patterns of Practice, by John C. Coates, IV; and Are M&A Contract Clauses Value Relevant to Target and Bidder Shareholders? (discussed on the Forum here) by John C. Coates, IV, Darius Palia, and Ge Wu.

Takeover targets often experience substantial share price appreciations around public announcements of mergers and acquisitions. Trading in anticipation of these announcements can considerably improve the performance of an investment strategy. In our paper, we analyze hedge fund and mutual fund holdings around takeover announcements to assess the differences in investment strategies across institutions in a sample of 7,184 M&A announcements during 1990-2015. We find that hedge fund ownership in impending takeover targets increases by 7.2% during the quarter prior to the merger announcement. On the other hand, mutual fund ownership in takeover targets decreases by 3.0% during the calendar quarter preceding the public merger announcement.

Our results on ownership changes are robust across transactions of different sizes, different takeover premia, and different deal characteristics. Our results also indicate qualitatively similar effects before and after Regulation Fair Disclosure.

We find that increases in hedge fund ownership and decreases in mutual fund ownership over several quarters increase the probability that a company becomes a takeover target in subsequent quarters. This analysis also allows us to control for common characteristics of the companies (e.g., industry, size, market-to-book, momentum) that might be used as trading signals by institutional investors. We find that the ownership changes by mutual funds and hedge funds remain an economically and statistically significant predictor of M&A transactions after controlling for these style characteristics.

Our findings on ownership changes might be affected by the affiliation of fund management companies with the advisors for the acquirers and targets. These asset management firms might obtain early access to the information about a forthcoming acquisition. We find that the ownership in a target firm by mutual funds affiliated with the target’s M&A advisor increases slightly several quarters prior to the M&A announcement. Conversely, we note that the ownership in a target firm by mutual funds affiliated with the acquirer’s M&A advisor declines in the quarters prior to the M&A announcement, consistent with our overall results.

We also evaluate whether our hedge fund results are driven by the activist hedge funds identified by Brav, Jiang, and Kim (2015). Of the 7,184 M&A takeover targets in our sample, only 76 are associated with hedge fund activism. Our results show that hedge fund activists significantly increase their stakes in these 76 target companies prior to M&A deal announcements. In contrast, ownership changes by non-activist hedge funds are less pronounced. These findings suggest activism as a possible channel that some hedge funds may use to generate gains. However, the ownership changes by activist hedge funds cannot explain most of the trading in takeover targets prior to the M&A announcement.

We analyze whether there are cross-sectional differences among institutional investors who trade the targets’ equity prior to merger announcements. We find significant persistence in the ownership stakes held across time by both mutual funds and hedge funds. Specifically, funds that allocate a higher weight in to-be targets a quarter prior to the announcement tend to allocate a higher portfolio weight to future targets as well. This evidence indicates that there are systematic differences in allocations toward upcoming targets across funds.

We investigate whether the allocation to future targets is related to the activeness of a fund. We find that mutual funds that are more actively managed tend to decrease their ownership of future takeover targets to a lesser extent. Thus, less active funds, which have been shown to exhibit lower investment ability than more active mutual funds, tend to forgo the largest benefits of takeover announcements by selling out their shares in takeover targets prematurely.

Our work contributes to the active debate on whether institutional investors profit from takeover announcements. Jegadeesh and Tang (2010) find that institutional investors whose main broker is also a target advisor are net buyers of target shares before announcements and their pre-announcement trades are significantly profitable.  Lowry, Rossi, and Zhu (2018) find similar results. In contrast, Griffin, Shu, and Topaloglu (2012) do not find much evidence to support that investment bank clients take advantage of takeover advising connections. Whereas those papers are primarily interested in short-term trading immediately prior to the merger announcement, we analyze trades over longer horizons for a broader set of mutual fund and hedge funds. We add to this literature by showing that, unlike mutual funds, some hedge funds accumulate large stakes in soon-to-be takeover targets.

This study also contributes to the literature that investigates the specific methods that institutional investors use to create value for their investors. Cohen, Frazzini, and Malloy (2008) find that fund managers exhibit superior performance when they trade shares of firms they are connected through their educational networks. Baker, Litov, Wachter, and Wurgler (2010) find  a significant amount of outperformance of mutual funds around corporate earnings announcements. We move this literature forward by showing that some investment managers create value by increasing their holdings in prospective takeover targets.

The complete paper is available here.

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