Acquisition Finance, Capital Structure and Market Timing

1、Acquisition Finance, Capital Structure and Market TimingAcquisition Finance, Capital Structure and Market Timing Theo Vermaelen and Moqi Xu* INSEAD, Fontainebleau Cedex, France May 2011 Abstract: We examine effects of capital structure management and misvaluation on the payment method in mergers and

2、 acquisitions. In a sample of 3,097 transactions, we find evidence both for leverage optimization and misvaluation as drivers for the decision to pay with cash or stock. Our evidence also shows that it is difficult to pay with overvalued stock unless justified by economic fundamentals. Few bidders t

3、ry and often only succeed after going hostile. Paying with cash while capital structure optimization suggests stock payment is more common. These firms are reluctant to pay with undervalued stock and experience positive long-term excess returns. JEL Classifications: G14, G34 Keywords: Mergers and ac

4、quisitions, capital structure, market timing, equity issues, share buybacks, mispricing * Theo.V, +33 (0) 1 60 72 44 32 and Moqi.X, +33 (0) 1 60 72 92 21. We would like to thank Denis Gromb, Pekka Hietala, Massimo Massa, Urs Peyer, Sudi Sudarsanam, Jun Zhou as well as pa

5、rticipants in the seminars at Chulalongkorn University, INSEAD, the Luxembourg School of Finance, Sebanci University, Tel Aviv University and the University of Antwerp. 1I. Introduction In this paper we examine how firms make acquisition finance decisions. In particular, we ask two questions. First,

6、 is the choice of payment method in an acquisition consistent with the predictions of the best empirical capital structure models, i.e. the models that have the largest predictive power of leverage ratios in the literature ? Second, can deviations from these predictions be explained by market timing

7、? Stock-financed acquisitions coincide with periods of high market valuation (e.g., Rhodes-Kropf, Robinson and Viswanathan (2005), Dong et al. (2006) and negative long-run returns (e.g., Asquith (1983), Agrawal, Jafee, and Mandelker (1992), Loughran and Vijh (1997), Rau and Vermaelen (1998). While i

8、t seems easy to conclude that overvalued acquirers have an incentive to pay with stock, it is less obvious to see why target firms should accept stock if paying with it provides a perfect signal for overvaluation. Possible explanations range from investor irrationality (Shleifer and Vishny (2003), c

9、orrelation in valuation errors (Rhodes-Kropf, Robinson and Viswanathan (2004) to shareholder inertia (Baker, Coval and Stein (2007) or governance problems at the target firm (Hartzell, Ofek and Yermack (2004). Acquisition finance can be driven by many motives other than misevaluation. In a recent pa

10、per Harford, Klasa and Walcott (2009) show that when a bidder s leverage is above an optimal leverage, it is less likely to finance its bid with debt than with equity. Other arguments include taxation of cash and stock offers (Gilson, Scholes and Wolfson (1988), risk-sharing (Hansen (1987) and diffe

11、rences in SEC requirements (Martin (1996). 2We argue that target firms have a reason to accept proposals for a stock-financed acquisition when the payment method choice can be explained by such rational motives. Issuing overvalued stock without another justification, however, will be problematic as

12、it will reveal to the management of the target firm that the bidder is overvalued. The target can then try to ask compensation for this by demanding more shares, which increases the cost to the bidder. If as a result the bidder is no longer able to compensate the losses from moving away from an othe

13、rwise optimal cash financing choice by issuing overvalued shares, the bidder has three choices: paying cash, walking away from the deal, or making a hostile bid directly to investors, hoping that they are less sophisticated than the target management. Consistent with this intuition, we find that onl

14、y 1% of the 2,978 firms in our acquisition sample make stock-financing decisions that cannot be justified by a prediction model based on capital structure concerns, controlling for transaction characteristics. A closer look at all announced (including unsuccessful) deals involving unanticipated stoc

15、k payment reveals that only 42% of such attempted acquisitions succeeds. Moreover, 52% of the unanticipated stock transactions are perceived as hostile, in contrast to 1% of anticipated stock transactions. Hence, issuing stock when the trade-off theory suggests the bidder should be pay with cash is

16、nearly impossible. Acquiring firms that are able to pay with overvalued stock and can justify their payment choice on the basis of the trade-off theory, experience long-term significant negative abnormal returns. In other words, it is possible to fool target shareholders, but only if the bidder can

17、tell a story that justifies the equity payment method. 3One can interpret our analysis as a test of capital structure in general. On the one hand, empirical capital structure models, such as Kayhan and Titman (2007) used by Harford, Klasa and Walcott (2009), estimate the relation between financial l

18、everage and a number of variables, such as profitability, growth opportunities, firm size, and tangibility of assets. The relevance of these variables is predicted by theories that argue that firms trade off tax benefits and benefits from reduced agency costs of debt financing against the expected c

19、osts of financial distress (Miller and Modigliani (1963), Jensen (1986), Harris and Raviv (1991), Myers (1977), Jensen and Meckling (1976). However, trade-off models assume markets are efficient and do not offer an explanation for the long-run negative (positive) abnormal returns after leverage decr

20、easing a(increasing) increasing events. On the other hand, the evidence of long-run abnormal returns is consistent with the market timing hypothesis, which predicts that firms want to issue stock when their shares are overvalued and buy back shares when their shares are undervalued (Baker and Wurgle

21、r (2002), Welch (2004) and Schleifer and Vishny (2003). The pure market timing hypothesis, however, is inconsistent with the empirical evidence that firms adjust their capital structure towards a time- a Long term negative abnormal returns after seasoned equity issues have been reported by Taggart (

22、1977), Marsh (1982), Asquith and Mullins (1986), and Loughran and Ritter (1995). Long term positive abnormal returns after share buybacks have been reported by Ikenberry, Lakonishok, and Vermaelen (1995). In the context of acquisitions, long term negative abnormal returns after equity financed trans

23、actions and positive long-term abnormal returns after cash financed transactions are reported by Asquith (1983), Loughran and Vijh (1997), Rau and Vermaelen (1998), Agrawal, Jaffee, and Mandelker (1992), and Dong et al. (2006). 4varying target (Hovakimian, Opler, and Titman (2001), Leary and Roberts

24、 (2005), Flannery and Rangan (2006), or Kayhan and Titman (2007). This slow adjustment to the target leverage is explained by adjustment costs, i.e. fixed transactions costs associated with issuing equity or buying back stock. In this context, the purpose of this paper is to reconcile the market tim

25、ing 6view which argues that firms do not have optimal capital structure ratios but time the market, and the dynamic static tradeoff theory which argues that firms drift away from optimal capital structure ratios until the costs from deviating become larger than the adjustment costs. Specifically, th

26、e goal of this paper is to show under which conditions market timing can dominate the predictions of the trade-off theory. Compared to examining cross-sectional or time series variations in capital structure ratios, studying actual capital structure decisions is, we believe, a more direct test of wh

27、ether managers care about reaching targets specified by empirical models. Indeed, capital structure ratios, especially the value of the equity, could be largely driven by events outside of control of management. In other words, a highly levered firm may be highly levered because its earnings and sto

28、ck price has collapsed, not because it deliberately wants to move to a higher leverage ratio. Acquisitions provide a particularly good context to study capital structure decisions because the financing decision can produce significant effects on the resulting leverage. In addition, they provide data

29、 on the target firm, i.e., the usage of fund raised, as opposed to equity issues which do not come with credible information on investment opportunities. 5The main contribution of our paper to the acquisition finance literature is our analysis of acquisition payment decisions that cannot be explaine

30、d by models based on the trade-off theory, even after controlling for transaction and firm characteristics. The most striking result in this paper is that only 1 % of the bidders in our sample pay with stock when the market expects them to pay with cash. Hence, market timing is only possible if the

31、bidder can make a case that equity finance makes sense. Paying with cash when the trade-off theory suggests paying with stock is no problem as in this case his target management does not care if he bidder shares are undervalued. Finally and on a somewhat technical note, we extend the methodology tha

32、t Harford et al (2009) develop to calculate optimal capital structures in a merger context. Harford et al predict the acquirer s optimal leverage measured by the Kayhan and Titman (2007) model. In contrast, we consider the combined post-acquisition capital structure of bidder and target, not the cap

33、ital structure of the bidder only. In particular, we compare the hypothetical capital structure after assumed cash payment to one after equity payment. This procedure is commonly used by investment bankers when they want to judge the feasibility (and determine the conditions) of debt financing in an

34、 acquisition and can lead to substantially different results if the target is large. We believe that introducing target firm information can not only benefit the acquisition finance literature, but the acquisition literature in general. The remainder of the paper is organized as follows. In section

35、II, we formulate testable hypothesis. Section III describes the data. We introduce the methodology in section IV. Section 6V tests to what extent acquisition financing decisions can be explained by the static trade-off and market timing hypotheses. In Section VI, we take a closer look at firms that

36、deviate from the trade-off prediction. Section VII examines to what extent long-term stock price stock price behavior and leverage development is consistent with the predictions of our theory. Section VIII provides robustness checks. Section IX summarizes our conclusions. II. Hypotheses and predicti

37、ons A. The combined static trade-off / market timing hypothesis In this paper we want to test whether bidders chose their acquisition payment method on the basis of: (i) fundamental motives, such as the static trade-off theory that trades off the tax advantages from debt financing against the expect

38、ed costs of financial distress and (ii) the market timing theory argues that firms may deviate from the static trade-off prediction if they either want to pay with overvalued shares or to avoid paying with undervalued shares. The bidder assesses over-or undervaluation by comparing its current market

39、 value (prior to the bid) with its own estimate of its present value of expected cash flows as a stand-alone company. He then has to decide whether he should pay with cash or with stock. The target firm may then infer from this choice of payment whether the acquirer shares are overvalued and ask for

40、 compensation for the overvaluation. We make two types of predictions. The first set of predictions is about financing behavior and the second set of predictions deals with long-run post-acquisition stock price behavior. 7A.1 Predictions about financing behavior There are essentially four possibilit

41、ies. Either the market timing theory contradicts the prediction to pay with cash or stock. In the other two cases both arguments give the same recommendation. We predict that bidders are more like to pay with cash when they are expected to do so. This is because as the target observes deviation, he

42、knows that the bidder shares are overvalued. As a result, the overvalued bidder has to increase the consideration. This implies that bidders who try to pay with stock will fail to obtain a benefit that compensates for the cost of deviating from the predicted financing method. Hence the bidder may as

43、 well decide to pay with cash or cancel the bid. Of course, when the bidder should pay with cash according to both arguments (i.e. the bidder shares are undervalued), we will observe cash transactions. This leads us to the first hypothesis: Hypothesis (1): When cash payment is predicted, the bidder

44、is more likely to pay with cash, regardless of over-or undervaluabtion of its stock. On the other hand, if the bidder should pay with stock according to the prediction, bidders that are undervalued enough will pay with cash. Firms that are overvalued and correctly valued want to issue equity. In oth

45、er words, it is no longer always optimal to follow the b Note that prior knowledge of the target firm about the acquirer s value has no impact on this conclusion. The target firms will always interpret an unjustified equity offer as a signal for overvaluation, no matter what their prior beliefs are.

46、 8prediction. Of course, target management, assisted by valuation experts such as investment bankers, may well conclude that the shares of the bidder are overvalued and ask for increased consideration, which means that bidders may be unable to benefit from issuing overvalued stock. But in this case

47、the bidder will still go ahead with the acquisition as the means of payment is not against the predictions of the trade-off hypothesis. Note also that if the bidder does not follow the trade-off prediction and pays cash, the target management knows that the bidder is undervalued. However, the target

48、 does not care as he is paid with cash. This leads us to the next hypothesis: Hypothesis (2): When equity payment is optimal according to the static trade-off theory, a correctly or overvalued bidder is more likely to pay with stock, while there is a threshold of undervaluation above which the bidde

49、r is more likely to pay with cash. That is, there will be a mixed distribution of payment method among bidders for whom equity payment is optimal according to the static trade-off hypothesis. - Table 1 approximately here - A.2 Predictions about long-run excess returns The market timing theory is a b

50、ehavioral theory: it assumes that markets can under-react to company specific events such as acquisitions. When bidders should pay with cash according to the static trade-off hypothesis, hypothesis (1) predicts that most firms will pay with cash. This includes undervalued, correctly valued as well a

51、s overvalued firms (The overvalued firms would like to pay with overvalued stock, but they cannot). So, in this case we predict no significant long-run excess returns. 9Hypothesis (3): When bidders pay with cash according to the prediction, long run excess returns should not be significantly differe

52、nt from zero. When the trade-off theory predicts equity issuance, some heavily undervalued firms may want to pay with cash. Although everyone (in particular the target management) should realize that the stock is undervalued, the market may still underreact. Overvalued firms have an additional reaso

53、n to issue stock, and in this case they may get away with their timing strategy if the target firm can t figure out the real motivation behind the payment choice. But even if target management figured this out, it does not mean that market participants will understand that the bidder shares are over

54、valued. This leads us to the following predictions: Hypothesis (4): When bidders should pay with stock according to the trade-off theory and they pay with cash, long-run excess returns will be positive. Hypothesis (5): When bidders should pay with stock according to the trade-off theory and they pay

55、 with stock, we expect long-run excess returns to be negative. - Table 2 approximately here - The last column in Table 1 and Table 2 summarize the predictions of this combined trade-off market timing hypothesis, for financing decisions and long term stock price behavior, respectively. For comparison

56、 we also include the predictions of pure trade-off and pure market timing. For example, a pure market timing hypothesis (e.g. Baker and Wurgler (2002), Welch (2004) predicts long term positive excess returns after cash offers and negative returns after equity offers. The combined trade-off market ti

57、ming hypothesis, on contrary, would predict no 10positive excess returns after cash offers if the payment method can be justified by economic fundamentals. B. Competing hypotheses: alternatives to market timing The competing hypotheses assume that deviations from prediction are driven by other consi

58、derations than market timing. According to the tax hypothesis firms prefer to pay with stock than with cash (Gilson, Scholes and Wolfson (1988). If a firm pays with cash, the selling shareholders have to realize capital gains taxes, but when the firm pays with stock, shareholders can defer the gain.

59、 To the extent that bidders have to compensate target shareholders for higher taxes (through a higher bid price), bidders prefer stock payment. This hypothesis predicts that firms will deviate from the prediction in only one direction: when the model predicts cash payment, firms may deviate and issue equity. But one should never observe firms that are predicted to pay stock and c