Is often used when the acquiring firm paid too high a premium to acquire the target firm

In this paper, we examine the gains to shareholders of firms that announce acquisitions of public firms, private firms, or subsidiaries of other firms. We consider these different types of acquisitions together since corporations making such acquisitions could be acquiring similar assets.1 Typically, acquisitions are sizable investments for the firms that undertake them. We form a sample of all such purchases over $1 million by public firms from 1980 to 2001 recorded by the Securities Data Corporation. After imposing some additional sampling criteria, we obtain a sample of 12,023 acquisitions. Such a comprehensive sample has not been studied before. The equally-weighted average announcement return for acquiring-firm shareholders in our sample is 1.1%, representing a gain of $5.61 per $100 spent on acquisitions. If the capital markets’ assessment is unbiased, this gain represents the economic benefit of the acquisition for the shareholders of the acquiring firm together with the stock-price impact of other information released or inferred by investors when firms make acquisition announcements.

The equally-weighted average announcement return implies that the wealth of acquiring-firm shareholders increases when acquisitions are announced. Strikingly, however, the average dollar change in the wealth of acquiring-firm shareholders when acquisition announcements are made is negative. From 1980 to 2001, the sample firms spent roughly $3.4 trillion on acquisitions and the wealth of the shareholders of these firms fell by $303 billion dollars (in 2001 dollars), for a dollar abnormal return, defined in Malatesta (1983) as the abnormal return times the firm's equity capitalization cumulated over the event window, of −$25.2 million per acquisition. The dollar abnormal return can differ in sign from the percentage abnormal return if the percentage abnormal return differs in sign for large and small firms. This is the case here. We define small firms in a given year to be firms whose capitalization falls below the 25th percentile of NYSE firms that year. Acquisitions by small firms are profitable for their shareholders, but these firms make small acquisitions with small dollar gains. Large firms make large acquisitions that result in large dollar losses. Acquisitions thus result in losses for shareholders in the aggregate because the losses incurred by large firms are much larger than the gains realized by small firms. Roughly, shareholders from small firms earn $9 billion from the acquisitions made during the period 1980-2001, whereas the shareholders from large firms lose $312 billion. Though it is common to focus on equally-weighted returns in event studies, it follows from these numbers that value-weighted returns lead to a different assessment of the profitability of acquisitions. The value-weighted return is −1.18%.

After documenting that small firms are good acquirers and large firms are not, we examine possible explanations for this size effect, defined as the difference between the abnormal returns of small acquirers and large acquirers. First, roughly one quarter of the firms acquiring public firms are small whereas half of the firms acquiring private firms are small. If acquiring private firms is more profitable than acquiring public firms, this could explain the size effect. Fuller et al. (2002) show for a sample of firms that make five or more acquisitions in the 1990s that abnormal returns are higher for firms acquiring private firms or subsidiaries than for firms acquiring public firms. Second, small firms are more likely to pay for acquisitions with cash than with equity. Travlos (1987) and others show that acquisitions of public firms paid for with equity are accompanied by lower announcement returns. However, Chang (1998) and Fuller et al. (2002) show that acquisitions of private firms paid for with equity do not have lower announcement returns than private acquisitions paid for with cash. Third, small and large acquirers have different characteristics. The literature has shown that a number of acquiring-firm and deal characteristics are related to announcement returns for public-firm acquisitions. For instance, Lang et al. (1991) and Servaes (1991) show that high q bidders have higher announcement abnormal returns for tender offer acquisitions and public-firm acquisitions, respectively, and Maloney et al. (1993) find that bidders with higher leverage have higher abnormal returns. We find that controlling for a wide variety of acquiring-firm and deal characteristics does not alter the size effect. In all of our regressions, the estimate of the size effect is positive and significantly different from zero at the 1% probability level.

A number of explanations have been offered for why the stock price of firms announcing an acquisition can be negative. Roll (1986) hypothesizes that managers of bidding firms may suffer from hubris, so they overpay. Travlos (1987) points out that firms with poor returns generally pay with equity, and Myers and Majluf (1984) show that firms that issue equity signal that the market overvalues their assets in place (the equity signaling hypothesis). A related hypothesis, formalized by McCardle and Viswanathan (1994) and Jovanovic and Braguinsky (2002), is that firms make acquisitions when they have exhausted their internal growth opportunities (the growth opportunities signaling hypothesis). Jensen (1986) argues that empire-building managements would rather make acquisitions than increase payouts to shareholders (the free cash flow hypothesis). Recently, Dong et al. (2002) show that firms with higher valuations have worse announcement returns. This could be because highly valued acquirers communicate to the market that these high valuations are not warranted by fundamentals, perhaps because they are undertaking efforts to acquire less overvalued assets with more overvalued equity (the overvaluation hypothesis).2 Finally, Mitchell et al. (2004) show that there is a price pressure effect on the stock price of the bidder for acquisitions paid for with equity because of the activities of arbitrageurs (the arbitrageur hypothesis).

For these hypotheses to explain the size effect for some or all types of acquisitions, they have to be more pertinent for large firms than for small firms. This is not implausible. Generally, the incentives of managers in small firms are better aligned with those of shareholders than is the case in large firms. In particular, Demsetz and Lehn (1985) find that managers in small firms typically have more firm ownership than managers in large firms. Managers of large firms might be more prone to hubris, perhaps because they are more important socially, have succeeded in growing the firm, or simply face fewer obstacles in making acquisitions because their firm has more resources. A firm may be large because its equity is highly valued, so a large firm is more likely to be overvalued. A firm that is further along in its lifecycle might be more likely to be large and to have exhausted its growth opportunities. Agency costs of free cash flow occur when a firm no longer has growth opportunities, which could be more likely for large firms than for small firms. Finally, arbitrageurs are unlikely to use their resources for a merger when the acquirer is a small firm because it will be too difficult and costly to establish large short positions.

We investigate whether these hypotheses are helpful in understanding the size effect. We provide evidence that managers of large firms pay more for acquisitions. The premium paid increases with firm size after controlling for firm and deal characteristics. Large firms are also more likely to complete an offer. This is consistent with hubris being more of a problem for large firms. We find that the combined dollar return of the acquired and acquiring firms for acquisitions of public firms is positive and significant for small firms but significantly negative for large firms. In other words, there are no dollar synergy gains for acquisitions by large firms given how synergy gains are typically computed (following the method proposed by Bradley et al. 1988), but there are dollar synergy gains for acquisitions by small firms. Percentage synergy returns are positive for acquisitions by large firms as well as by small firms, but they are significantly higher for acquisitions by small firms. Of course, the synergy gain estimate for acquisitions by large firms could be made negative by the adverse information revealed about the acquirer through the acquisition announcement rather than by the adverse impact on shareholder wealth of the acquisition itself, although it is not clear why large acquirers reveal relatively more adverse information than do small acquirers.

We also provide evidence that is inconsistent with the overvaluation hypothesis. In contrast to the market value of a firm's equity, the book value of a firm's assets is unlikely to be correlated with the overvaluation of the firm's stock price. Consequently, if the size effect is due to the fact that large firms tend to be overvalued, it should disappear when we use the book value of the firm's assets as a size measure. Nonetheless, we find that the size effect holds when we use the book value of a firm's assets instead of the firm's market value of equity. Though the outcome of the acquisitions by large firms is consistent with the existence of agency costs of managerial discretion, there is little support for the free cash flow hypothesis. Finally, we investigate the hypothesis that the market makes systematic mistakes in evaluating acquisitions that it rectifies over time. In this case, acquisitions by small firms would be followed by negative abnormal returns and acquisitions by large firms would be followed by positive abnormal returns. This explanation cannot account for the size effect. The market seems fairly efficient in incorporating the information conveyed by acquisition announcements in the stock price.

The paper is organized as follows. In Section 2 we describe our sample and document that abnormal returns for acquisition announcements are significantly positive and negatively correlated with firm size. In Section 3, we demonstrate that the size effect is robust to firm and deal characteristics. In Section 4, we investigate possible explanations for the size effect. We conclude in Section 5.

Announcement returns for successful acquisitions

To estimate the shareholder gains from acquisitions, we consider acquisition announcements that are successful and result in a completed transaction. In 3 Is the size effect explained by firm and deal characteristics?, 4 Why do large firms have lower announcement abnormal returns than small firms?, we include unsuccessful acquisition announcements to investigate whether this focus introduces a bias in our analysis and find that it does not. We first describe our sample and then estimate the

Is the size effect explained by firm and deal characteristics?

We first show how firm and deal characteristics differ between large and small acquirers. We then explore whether these differences explain why the abnormal returns of large and small acquirers differ. To do that, we compare abnormal returns for similar deals across large and small acquirers and then use multivariate regressions.

Why do large firms have lower announcement abnormal returns than small firms?

In this section, we explore whether the hypotheses advanced to explain the negative abnormal returns associated with acquisitions are more pertinent for acquisitions by large firms. We first examine whether the overvaluation, equity signaling, growth opportunities signaling, and free cash flow hypotheses can explain the size effect. This would require these hypotheses to predict lower returns for acquisitions by large firms, but the hypotheses would not apply to acquisitions by small firms or

Conclusion

We have shown that small firms fare significantly better than large firms when they make an acquisition announcement. Overall, the abnormal return associated with acquisition announcements for small firms exceeds the abnormal return associated with acquisition announcements for large firms by 2.24 percentage points. Except for acquisitions of public firms paid for with equity, small firms gain significantly when they announce an acquisition. Large firms experience significant shareholder wealth

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