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In this article, we examine acquiring companies’ cash flow performance after a merger in the fifty largest U.S. industrial takeovers from 1979 to mid-1984. In an earlier study, we showed that the mergers in this same sample created new value for the stockholders of the target company and the acquiring company combined.1 But our results here show that the acquirers did not generate any additional cash flows beyond those required to recover the premium paid. However, while the takeovers were break-even investments on average, the profitability of the individual transactions varied widely.
There were two distinct types of takeovers in our sample: (1) friendly transactions that typically involved stock payment for firms in overlapping businesses, which we called “strategic” takeovers; and (2) hostile transactions that generally involved cash payments for firms in unrelated businesses, which we labeled “financial” takeovers.2
Strategic takeovers have several potential advantages over financial transactions. Because they combine firms in related businesses, strategic transactions are likely to offer greater business synergies than financial transactions. Acquiring managers in friendly strategic takeovers are more familiar with the target company’s business and have access to proprietary information in negotiations, which improves their accuracy in valuing the target. Further, stock-financed transactions reduce the cost of valuation mistakes because the stockholders of the target company partially bear some of the consequences of the errors. Finally, friendly takeovers are less likely to experience disrupted operations after the takeover that may destroy the target firm’s intangible assets. For all these reasons, some cite strategic takeovers as potentially more profitable than financial transactions.
On the other hand, if friendly strategic takeovers are manifestations of free cash flow problems, they are likely to be less profitable than financial transactions, which replace inefficient management and reduce agency costs.
Our study results show that strategic takeovers generated substantial gains for acquirers. Financial transactions broke even at best. The premiums in strategic takeovers were lower than in financial deals and the synergies were higher, indicating that strategic acquirers were able to pay less to get more.
We also examine the relation between the profitability of takeover transactions and three transaction characteristics that management controlled.3 Those characteristics were: (1) the target managers’ attitude, (2) the form of payment, and (3) the degree of overlap of the merging firms’ businesses.
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1. P.M. Healy, K.G. Palepu, and R.S. Ruback, “Does Corporate Performance Improve after Mergers?,” Journal of Financial Economics, volume 31, 1992, pp. 135–176.
2. We label takeovers as strategic and financial, following the popular usage of these terms in the financial press.
3. For an examination of the relative profitability of different types of takeovers, see:
R. Morck, A. Shleifer, and R. Vishny, “Do Managerial Motives Drive Bad Acquisitions?,” Journal of Finance, volume 45, 1990, pp. 31–48;
L. Lang, R. Stultz, and R. Walking, “A Test of the Free Cash Flow Hypothesis: The Case of Bidder Returns,” Journal of Financial Economics, volume 29, 1991, pp. 315–336;
D. Ravenscraft and F.M. Scherer, Mergers, Sell-offs, and Economic Efficiency (Washington, D.C.: The Brookings Institution, 1987);
M. Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review, volume 65, May–June 1987, pp. 43–59; and
S. Kaplan and M. Weisbach, “The Success of Acquistions: Evidence from Divestitures,” Journal of Finance, volume 47, 1992, pp. 107–138.
The first two studies use acquiring firms’ announcement returns, and the last three examine post-takeover divestitures by acquirers to assess the relative success of different types of acquisition. In contrast, we analyze post-takeover cash flow performance.
4. See: M.C. Jensen and R.S. Ruback, “The Market for Corporate Control,” Journal of Financial Economics, volume 11, 1983, pp. 5–50.
5. This suggestion is not unreasonable, given the market’s apparent difficulty in interpreting routine information, such as quarterly earnings announcements. See:
V.L. Bernard and J. Thomas, “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings,” Journal of Accounting and Economics, volume 13, 1990, pp. 305–340.
6. For a summary of evidence on negative post-merger abnormal stock returns for acquirers, see:
Jensen and Ruback (1983).
Franks et al. argue that these findings are spurious and are caused by earlier errors in the market benchmark used to compute abnormal returns. See:
J. Franks, R. Harris, and S. Titman, “The Postmerger Share-Price Performance of Acquiring Firms,” Journal of Financial Economics, volume 29, 1991, pp. 81–96.
7. The aggregate market value of equity of the fifty target firms in our sample one year prior to the acquisition is $43 billion.
8. Strictly speaking, our measure is working capital from operations and not operating cash flow. It excludes all noncurrent accruals but includes some current accruals, such as accounts receivables and payables. However, we believe that our measure reflects long-term operating performance with less noise than a strict cash flow measure.
9. For an illustration of this point, see: Healy et al. (1992).
10. We used Value Line industry definitions to control for the industry effects.
11. We collected industry data from Compustat Industrial and Research files.
12. To calculate the sample median pretax operating cash flow return for years –5 to –1, we first computed the median return in these years for each sample firm. The reported sample median was the median of these values. Sample median returns in the post-merger period were calculated in the same way. Throughout the paper, we used a two-tailed test and a 5 percent or lower cutoff significance level. This is equivalent to a 2.5 percent cutoff one-tailed test for the many cases where the hypotheses examined are directional.
13. Healy et al. (1992).
14. We evaluated the merging firms’ annual reports, takeover prospectuses, Value Line reports, and Moody’s Industrial Manuals. For a complete description of the business overlap classifications for each sample transaction, see:
Healy et al. (1992).
15. S.C. Myers and N.S. Majluf, “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have,” Journal of Financial Economics, volume 13, 1984, pp. 187–222.
16. Y. Huang and R. Walkling, “Target Abnormal Returns Associated with Acquisition Announcements: Payment, Acquisition Form, and Managerial Resistance,” Journal of Financial Economics, volume 19, 1987, pp. 329–349; and
P. Asquith, R. Brunner, and D. Mullins, “Merger Returns and the Form of Financing” (Cambridge, Massachusetts: MIT Sloan School of Management, working paper, 1988).
17. Twenty-four of the sample firms did not fall within our classifications of strategic and financial takeovers.
18. When the post-takeover cash flow returns are ranked for all fifty sample transactions, ten of the fourteen strategic takeovers are in the top half of the sample; only four of the twelve financial takeovers are in the top half of the sample.
19. Risk-adjusted returns, computed using premerger announcement market model estimates, are similar to the market-adjusted returns reported in this paper.
20. For evidence consistent with this assumption, see:
P. Asquith and E.H. Kim, “The Impact of Merger Bids on Participating Firms’ Security Holders,” Journal of Finance, volume 37, 1982, pp. 1209–1228.