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Behavioural Issues in Corporate Takeover Bids

Andrs Duarte Otero
A third challenge to the claim that mergers create value stems from the finding that all of the gains from mergers seem to accrue to the target firm shareholders. We would like to believe that in an efficient economy, there would be a direct link between causes and effects, that mergers would happen for the right reasons, and that their effects would be, on average, as expected by the parties during negotiations. However, the fact that mergers do not seem to benefit acquirers provides reason to worry about this analysis.1

1. Introduction. Experimental economics attempts to use controlled experiments to corroborate or refute the predictions made by economic theory. Although the field has yielded some striking

contradictory results, laboratory replications of markets in the form of oral auctions have overwhelmingly tended to confirm the assumptions of standard economic theory. Even in experiments with very few traders, after a small number of trading sessions or periods, the market unequivocally converges towards the standard competitive equilibrium. However,

despite virtually all experiments in oral auction markets converging towards efficient equilibriums, there is strong evidence that the basic economic conditions of the auction exert considerable influence over the path this convergence takes. While the market always stabilizes at the competitive equilibrium regardless of variations in the relative elasticities of the supply/demand curves and the institutional rules of the auction, the direction of convergence and thus the distribution of income and profits during the equilibration stage- differs greatly depending on these conditions. 2

Gregor Andrade, Mark Mitchell, Erik Stafford. New Evidence and Perspectives on Mergers. The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 103-120. American Economic Association. 2 Charles R. Plott. Industrial Organization Theory and Experimental Economics. Journal of Economic Literature, Vol. 20, No. 4 (Dec., 1982), pp. 1485-1527. American Economic Association.

Of all the varieties of oral auction institutions replicated in laboratories, the one-sided auction yields the most dramatic influence on trading patterns during the convergence period. In one-sided auctions, a buyer (seller) makes bids (offers), which a seller (buyer) can only accept or reject. This institution heaps full

Figure 1. One-Sided Oral Offer Auction

responsibility for articulating the terms of the auction on one party, limiting the other partys input to either accepting or rejecting these terms. Experimental results (Plott and Smith, 19783; Smith, 19644) show that the approach to equilibrium is from above (below) if the auction is a one-sided bid (offer) auction. When buyers
Convergence to competitive equilibrium price (dotted line) occurs from below

bid and sellers merely reject or accept, the initial (disequilibrium) trades tend to be higher than the competitive equilibrium price. When sellers make offers and buyers roles are restricted to accepting/rejecting, we see the opposite effect, and the market price approaches the equilibrium from below (see figure 1). The adjustment period during which the disequilibrium trades occur- allows for economic losses and profits to be made. Given trading patterns during these initial iterations in one-sided oral auctions, the overall distribution of income will be biased against the side dictating the terms. The accepting/rejecting side will accrue the bulk of the abnormal economic profits. vice-versa. In one-sided auctions, sellers will prefer that buyers bid, and

Charles R. Plott, Vernon L. Smith. Experimental Examination of Two Exchange Institutions The Review of Economic Studies, Vol. 45, No. 1 (Feb., 1978), pp. 133-153. American Economic Association. 4 Vernon L. Smith. Effect of Market Organization on Competitive Equilibrium. The Quarterly Journal of Economics, Vol. 78, No. 2 (May, 1964), pp. 182-201. MIT Press.

The research behind this paper failed to uncover any theoretical modelling of these empirical findings. However, Charles Plott conjectures that this behaviour may be a

manifestation of counterspeculation on behalf of the accepting side: i.e. the agents in the group accepting or rejecting the offer collectively anticipate the potential for increased bids (lower offers) as buyers (sellers) compete against each others bids (offers). This behaviour eventually recedes with repeated iterations, and the market eventually converges on the equilibrium dictated by standard economic theory. Moving beyond the ivory tower of controlled laboratory settings and into the mud of the market place, corporate takeover bids for publicly traded firms should provide ample data to test how well these experimental results hold up in real-world versions of one-sided auctions. At this point, it is worth mentioning that the previously cited experimental results refer specifically to oral auctions. However, it is hard to see why counterspeculative behaviour should be significantly affected by a shift from oral to other forms of communication. When a firm decides to acquire a listed company, the most common method of attempting to execute this transaction is through the tender offer process. According to the SEC: A tender offer is a broad solicitation by a company or a third party to purchase a substantial percentage of a companys Section 12 registered equity shares or units for a limited period of time.5 This offer is often conditional on several factors, and is likely to be revised throughout the negotiation process. Holders of the target companys stock have a limited period to act upon the acquiring firms tender offer, throughout which it is assumed they judge whether the pershare price implied by the tender offer meets their personal valuation of said share. The process is thus a one-sided auction, in which the buyer announces a series of bids (although in certain

Tender Offer. http://www.sec.gov/answers/tender.htm

occasions the acquirer finds enough subscribers to the initial tender offer so as to not be forced into making additional bids) and the sellers accept or reject. There exists a well documented trend of corporate acquisitions destroying value for holders of the acquiring companys stock. That is, holders of the acquiring companys shares suffer a post-acquisition capital loss on the equity they held in the acquiring firm previous to the transaction. The opposite effect is observed for shares of the target firm. The continuous occurrence of said value destruction can be ultimately pinned on inflated and thus inefficientbids on behalf of acquiring firms. Even if there exists some intrinsic characteristic to

acquisitions which tends to lead to a decrease in the fundamental value of the acquiring firms post-transaction equity, this should eventually be built into acquirers expectations and thus be reflected in a lower willingness to bid. Like the trader subjects in the initial iterations of Smith and Plotts one-sided oral offer auction, managers at acquiring firms would seem to be making bids above the efficient price of the good being traded. Specifically, such a trend would imply that acquiring firms make bids in excess of the discounted value of the target firms estimated future cash flows; as obtained by optimal forecasts employing all available public information. If agents in the market for corporate acquisition behave similarly to the subjects in Smith and Plotts experiments, then such value destruction should be expected at first, though one would expect it to decrease with the passage of time and number of transactions. Basically, we should not be surprised in finding evidence of an initial trend of takeovers with bids above accurate valuations of the target firms. However, said trend should decrease as the corporate takeover market matures, converges towards equilibrium, and prices increasingly reflect efficient valuations. Value destruction (creation) for acquiring (target) firms should eventually disappear .

2. The Data A wealth of data has been collected and analyzed in an attempt to understand the relationship between corporate takeovers and value creation/destruction. The bulk of these investigations have taken the form of short-window event studies, concentrating on the behaviour of the involved firms stock prices at the time of the transaction announcement. The following table provides some descriptive statistic constructed by Andrade, Mitchell and Stafford using the University of Chicagos Centre for Research in Security Prices (CRSP) database.

Figure 2.

The statistics reflect the change in stock price for the three day period beginning the day before the announcement and ending the day after the announcement, and for the longer period beginning twenty days before the announcement of the deal and ending upon the completion of the transaction. Assuming that capital markets are able to efficiently incorporate public

information, the following statistics should reflect an unbiased estimate of the expected value

creation/destruction unleashed by the announced takeovers.6 Since for the short time periods considered, the expected return of any stock would be approximately zero under any model, any non-zero percentage change in stock price over the specified periods is considered to be an abnormal return.7 From the statistics, it is clear that holders of the target firms stock benefit unequivocally. The average abnormal returns are 16% and 24% for the 3 day and 20 day periods, respectively. More importantly, both are statistically significant at the 1 percent level. relationship for holders of the acquiring firms equity is less unambiguous. The implied Although the

abnormal returns are negative for both windows and within all three periods studied- , none reach the conventional threshold levels of statistical significance. Nevertheless, this perfunctory glance at stock performance for the two counterparties seems to fit in with the first part of our hypothesis. Namely, that the income distribution is tilted towards the seller in these one-way bidder auctions. Nevertheless, the most important finding in the laboratory auctions we are seeking comparison with is the eventual convergence of the market towards equilibrium. We should thus expect the abnormal returns to takeover announcements to converge towards zero as the market for takeovers matures and goes through repeated iterations. Unfortunately, the data blatantly contradicts this, as the abnormal returns for both the acquiring and target firms shares are remarkably stable over time (and do not converge to zero). 3. Analysis Before conceding defeat, it would be wise to consider the specificities which differentiate the M&A market from the controlled experiments carried out by Smith and Plott. In Smith and

Gregor Andrade, Mark Mitchell, Erik Stafford. New Evidence and Perspectives on Mergers. The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 103-120. American Economic Association. 7 Gregor Andrade, Mark Mitchell, Erik Stafford. New Evidence and Perspectives on Mergers. The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 103-120. American Economic Association.

Plotts experiments, repeated iterations or trading periods- were carried out by the same traders. In this sense and perhaps the main reason behind the remarkably efficient results achieved by the market over time- the subjects acquire trading experience.8 As is not difficult to imagine, the market for firms is not one bestowed with tremendous liquidity or frequent volumes. Transactions are extremely complex, tremendously expensive and sought out for rather particular reasons. Consequently, the learning-by-doing which probably occurs in Smith and Plotts experimental markets would take a lot longer to occur in the market for M&A, if at all. Naturally, one may counter that although single firms are not likely to engage in serial acquisitions, intra-firm labour movements within an industry might facilitate the accumulation of takeover experience within a sector as a whole. Consider two firms operating in the same sector. Though Firm A may not engage in repeated acquisitions, it could easily poach management with M&A experience from Firm B. However, empirical work by Andrade, Mitchell and Stafford shows that M&A activity tends to occur in industry-specific clusters, often as a response to oneoff exogenous shocks to said industries.9 So although economies experience acquisitions on a frequent basis, a particular industry may not. A flurry of takeovers within a sector is often followed by an extended industry-wide M&A drought. It might so happen that the extended time period between M&A waves for a specific industry is such that the learning-by-doing effect observed in Smith and Plotts traders is severely impeded. Further, it is important to consider the varying degree to which experience from previous transactions is applicable to future acquisitions. While Smith and Plotts subjects traded a single good over repeated iterations, firms often use acquisitions to diversify their business lines. The

The explanation of convergence towards efficient outcomes in laboratory experiments through the accumulation of experience is a common theme throughout much of both Vernon Smith and Charles Plotts work. 9 Gregor Andrade, Mark Mitchell, Erik Stafford. New Evidence and Perspectives on Mergers. The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 103-120. American Economic Association.

goods traded for in subsequent iterations might differ vastly. The lessons learnt in acquiring a telecommunications company may not readily translate into a real estate deal. Research focusing on the effect of firm characteristics on acquisition performance provides a good deal of evidence to support this caveat. Several papers imply that corporations undertaking repeated, highly related acquisitions tend to outperform both sporadic acquirers, and those taking over firms with dissimilar business lines (Porter, 198710, 199611; Ravenscraft and Scherer, 198712). The findings of Hayward (2002) study are less clear cut, with similarity of previous acquisitions having a positive coefficient on announcement returns, yet overall acquisition experience having a negative (albeit insignificant) coefficient.13 4. Areas for Further Research As the findings of the literature on the determinants of value creation and destruction in acquisitions suggest, the degree of uniformity of an acquiring firms iterative forays into the takeover market has a considerable effect on the performance of these transactions. Given the huge differences in the due diligence and execution of takeovers of business in different industries, one would expect the learning-by-doing effect exhibited by Smith and Plotts subject to be markedly weaker within the wider corporate takeover market. Further, given the extended time periods between industry-clustered M&A waves and the barriers to human capital transfers amongst different industries (as well as amongst the industry-specific corporate finance divisions at the investment banks that provide advice for these transactions) it is not surprising that the market for takeovers does not seem to exhibit as much experience retention as Smith and Plotts laboratory markets.
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Michael E. Porter. From Competitive Advantage to Corporate Strategy. Harvard Business Review. Vol. 65, No. 3, pp.43-49. Michael E. Porter. What Is Strategy?. Harvard Business Review. Vol. 74, No. 6, pp.61-78. 12 D.J Ravenscraft, Frederic M. Scherer. Mergers, Selloffs and Economic Efficiency. Brookings. 1987. Washington D.C. 13 Mathew L. A. Hayward. When Do Firms Learn From Their Acquisition Experience? Evidence from 1990-1995. Strategic Management Journal. Vol. 23, No. 1 (Jan., 2002), pp. 21-39. John Wiley & Sons.

However, the available data is not sufficient to dismiss the possibility of Smith and Plotts findings extending to the market for acquisitions. More refined datasets, along with better-tailored econometric models, might well remove the noise which could be confounding the statistical findings. A fruitful avenue of research might involve categorizing the takeover announcements studied in Andrade, Mitchell and Staffords paper into industry groups. Average announcement-period abnormal returns could be computed for the industry subsets in the each of the three time periods. Cross-comparison of average abnormal announcement returns for

takeovers in different industries could be analyzed to see if these are significantly lower for sectors experiencing a second major takeover wave (such as oil and gas in the 1980s, metal mining in the 1990s or real estate in the 1990s. See figure 3.). Subsequently, we might be more successful in finding a negative relationship between abnormal returns, and industryspecific acquisition experience.
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Figure 3.

An alternative line of inquiry might consider expanding on Haywards organizational learning study. The main body of his paper consisted on regressing acquisition announcement returns for acquiring firms upon firm-specific characteristics (similarity of target to existing business line, previous takeover experience, deal financing method, etc..). Restricting the sample of takeovers studied to those in which both the acquirer and target belonged to the same industry

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would greatly increase the extent to which parallels could be drawn between empirical findings in the M&A market and Smith and Plotts results. Individual takeover announcements could then be grouped by the number of previous acquisitions under the acquirers belt. Average abnormal returns from takeover announcements could be calculated for each group so as to test for evidence of their convergence to zero with increasing sector-specific experience. Similarly, coefficients relating acquisition experience to announcement results could be re-calculated based on this new restricted sample (likewise, one could develop dummy variables for the different number of previous acquisition groups). Were these co-efficients to still fail to converge to zero (as Smith and Plotts results would imply), a researcher might still find a decreasing trend and a convergent limit amongst them; implying that while acquirers will systematically overpay for target firms, there is at least some evidence of positive yet diminishing returns to market interaction (or in our case, takeover experience). This would be consistent with the decelerating trend towards equilibrium exhibited in figure 1. 5. Addendum/Further Speculation It is another empirical curiosity that corporate takeovers financed with stock tend to destroy more value for the acquiring firm than those financed with cash. Several hypotheses aimed at explaining this recurring occurrence have been conjectured, the most prominent ones relying on arguments regarding the informational asymmetries between management and the shareholding public (The common story is that management is more likely to use equity to finance a takeover when they consider the firm to be over-valued. The announcement of the stock financing of a deal is thus perceived by the market to be a signal of this, resulting in a fire-sale of the acquiring firms shares.) Most of the literature cited in this paper makes reference to this phenomenon. Accordingly, it seems only natural that a paper with a title such as this one should attempt to cast a behavioural slant on this well-observed phenomenon (see figure 4.).

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Figure 4.

Money illusion is defined as the behavioural tendency to use nominal rather than real magnitudes of wealth. Although the term is most commonly used to describe how the effects of inflation are often ignored when computing monetary returns, it could perhaps be applied to management using slacker standards of accounting when computing the real cost of stock financing. While changes in cash reserves affect the bottom line directly, there is no direct link between stock dilution and operating performance. Further, although equity issues affect share value directly, the way this equates cognitively into managers perception of the firms performance might differ from how the very concrete and tangible cost of the drain in a firms cash reserves resulting from cash financing does. Additionally, when one considers the degree of uncertainty inherent in the average share price fetched during a share issue, one can imagine how managers might be more prone to making faulty valuations or consciously elevated bids when these involve payment in stock. The exploration of this relationship requires knowledge of the psychology of perception and the cognitive processes behind monetary valuations which lie far beyond the scope of this paper and its author. Nevertheless, this offers a new angle on a well recorded phenomenon which might well be worth exploring.

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Bibliography for Figures: Figure 1: Charles R. Plott. Industrial Organization Theory and Experimental Economics. Journal of Economic Literature, Vol. 20, No. 4 (Dec., 1982), pp. 1485-1527. American Economic Association. Figure 2: Gregor Andrade, Mark Mitchell, Erik Stafford. New Evidence and Perspectives on Mergers. The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 103120. American Economic Association.

Figure 3: Gregor Andrade, Mark Mitchell, Erik Stafford. New Evidence and Perspectives on Mergers. The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 103120. American Economic Association. Figure 4: Gregor Andrade, Mark Mitchell, Erik Stafford. New Evidence and Perspectives on Mergers. The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 103120. American Economic Association.