Industry Asset Revaluations around Public and Private Acquisitions

Summary of the findings:

We study whether M&A activity improves the informational efficiency of financial markets – i.e., the ability of asset prices to reflect accurately fundamentals. The motivation for our analysis takes roots in two well-known observations. First, announcements of M&A transactions are important events that are closely followed by market participants as they reveal new information about the value of merging firms (e.g., the expected synergies), but also about their respective industries. Second, M&A transactions tend to occur when the market prices of real assets diverge from their fundamental values. To the extent that corporate insiders are better informed about fundamentals than investors (i.e., outsiders) are, they can profit by buying undervalued assets. We posit that when they do so, part of their private information is revealed to outsiders, who can then use this information to revalue other assets in the same industry. A central pillar of financial economics is that information-based trading renders financial markets more informationally efficient. We investigate whether trading in real assets by informed corporate managers might have similar implications. We label this hypothesis the “revaluation” hypothesis.

Testing this hypothesis is challenging because stock prices are affected by both non-fundamental factors and information related to the fundamental implications of the transactions. For example, the revaluation of firms involved in a transaction may reflect expected operational synergies, the price paid for the assets, or anticipated management changes. To overcome this challenge, we study the revaluations of horizontal peers that are not involved in the transactions. This approach offers two important advantages. First, peers’ revaluations are arguably less related to information specific to the transaction and the involved firms and are thus more likely to capture information pertaining to the stand-alone value of assets in the industry. Second, we can exploit the variation in the revaluations across deals and peers to develop a novel discriminant prediction of the revaluation hypothesis: The sign of peers’ revaluation around horizontal deals should depend on the ownership status of the target company (i.e., private or public).

Suppose that, for fundamental reasons (e.g., synergies), an acquirer is interested in purchasing one of two potential targets with identical fundamentals, but distinct ownership status. One is public and the other is private. If the acquiring manager is perfectly informed about the targets’ identical fundamentals, the choice solely depends on the purchase price. The price may differ across targets because the valuation of public firms is more sensitive to non-fundamental price fluctuations. Therefore, if the acquisition prices of the two targets differ only because investors’ overall pricing of public firms deviates from fundamentals, observing the acquisition of the public or private target might reveal information about industry-wide misvaluation. Because the acquiring manager knows the targets’ fundamentals, the acquisition of the public (private) target indicates the public firm as undervalued (overvalued). If acquisitions reveal information about the valuation of related assets, the sign of peers’ revaluations should depend on the ownership status of targets, with investors revaluing peers positively around acquisitions of public targets, and negatively when targets are private. Crucially this prediction is unique to our hypothesis, as peers’ revaluations are unlikely to depend on the ownership status of the target if acquisitions reveal information about fundamental changes.

To test this hypothesis, we use a large sample comprising all economically relevant acquisition transactions involving U.S. private and public firms (deals above $10 million). We focus on horizontal transactions, in which the informational advantage of managers is likely to be more pronounced. The sample includes 7,994 horizontal transactions over the period 1990-2015. We define revaluations based on cumulative abnormal returns (CARs) for 4,318 distinct industry peers around acquisitions announcements (252,979 unique CARs). We find sharp differences in peers’ revaluations across transactions involving public and private targets. The revaluation of peers is significantly negative after deal announcements involving private targets (88% of all deals and 50% of deal value in our sample), and positive following public acquisitions. The difference is economically large, with average peers’ revaluations of -0.11% to -0.20% after private acquisitions compared to 0.07% to 0.34% after public ones, depending on the method used to calculate revaluations. This revaluation “spread” between private and public deals remains when we control for peer characteristics (e.g., their size, age, profitability, market-to-book ratio) and deal characteristics (e.g., the value of the transaction or the status of acquirers).

To disentangle the revaluation hypothesis from alternative explanations (e.g., peers’ revaluations reflecting the anticipated real implications for industry peers), we study the determinants of peers’ revaluations as a function of peer and deal characteristics. We find that peers displaying signs of over-valuation experience revaluations that are more negative. In sharp contrast, the sign and magnitude of peers’ revaluations appear largely unrelated to fundamental variables such as their size, age, profitability, or access to finance. We also show that the peers’ revaluation spread varies systematically with well-known proxies for overall market misvaluation. Investors appear to be more responsive to the information revealed by corporate transactions when the market value of assets is likely to deviate more from fundamentals.

A key assumption underlying our hypothesis is that managers are able to detect part of the industry-wide deviations of stock prices from fundamentals to decide opportunistically on the type of their acquisition targets. Examining insiders’ trading behavior around horizontal acquisitions, we find that corporate insiders purchase their own stock significantly more in quarters featuring more acquisitions of public firms in their industry, which we argue arises when publicly traded assets (including their own firm) are undervalued. In contrast, insiders sell their firm’s stocks more intensively in quarters featuring more acquisitions of private firms (i.e., when public firms are overvalued), suggesting that managers detect partly deviations from fundamentals.

Furthermore, the average peers’ revaluation observed in an industry-month significantly predicts the future returns of that industry over different horizons. Specifically, industry-months displaying positive (negative) average peers’ revaluations around M&A announcements are followed by positive (negative) industry returns. To the extent that misvaluation is gradually corrected over time, the sign and magnitude of peers’ revaluations around horizontal transactions (i.e., a signal about industry-wide misvaluation) act as predictors of the direction and size of the observed overall stock price corrections (i.e., future industry returns). Our findings thus suggest that an active market for secondary assets helps incorporating information into prices, bringing them closer to fundamentals.

The results in this paper add to the literature studying the implications of stocks’ misvaluation in general and its role in mergers and acquisitions in particular. Despite ample evidence indicating that many transactions are driven by firms’ misvaluation (i.e., over- or undervaluation), surprisingly little is known about whether their announcements reveal information about firms’ stand-alone values to investors and whether investors update their views and revalue related assets. Our results also add to the literature studying how managers take advantage of temporary deviations of stock prices from fundamentals, and to the literature studying the effects of acquisitions on rivals, customers, and suppliers.