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Behavioural Issues in Corporate Takeover Bids
Andrés 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.

One-Sided Oral Offer Auction responsibility for articulating the terms of the auction on one party. a buyer (seller) makes bids (offers). the overall distribution of income will be biased against the side dictating the terms. 78. the one-sided auction yields the most dramatic influence on trading patterns during the convergence period. pp. 19644) show that the approach to equilibrium is from above (below) if the auction is a one-sided bid (offer) auction. 1978). Vernon L.. Vol. and the market price approaches the equilibrium from below (see figure 1). Plott. limiting the other party’s input to either accepting or rejecting these terms. which a seller (buyer) can only accept or reject. 19783.2 Of all the varieties of oral auction institutions replicated in laboratories. Smith. Smith. 1 (Feb. This institution heaps full Figure 1. No. American Economic Association. Smith.” The Quarterly Journal of Economics. 1964). In one-sided auctions. we see the opposite effect.allows for economic losses and profits to be made. the initial (disequilibrium) trades tend to be higher than the competitive equilibrium price. 45. vice-versa. 133-153. Given trading patterns during these initial iterations in one-sided oral auctions. The adjustment period –during which the disequilibrium trades occur. When sellers make offers and buyers’ roles are restricted to accepting/rejecting. In one-sided auctions. 4 Vernon L. When buyers Convergence to competitive equilibrium price (dotted line) occurs from below bid and sellers merely reject or accept. Vol. MIT Press. and Charles R. 2 (May. “Experimental Examination of Two Exchange Institutions” The Review of Economic Studies. Experimental results (Plott and Smith. sellers will prefer that buyers bid. 182-201. The accepting/rejecting side will accrue the bulk of the “abnormal” economic profits. “Effect of Market Organization on Competitive Equilibrium. No. pp. 3 .

This behaviour eventually recedes with repeated iterations. the most common method of attempting to execute this transaction is through the tender offer process. and is likely to be revised throughout the negotiation process. Holders of the target company’s stock have a limited period to act upon the acquiring firm’s tender offer. However. Moving beyond the ivory tower of controlled laboratory settings and into the mud of the market place. 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 other’s bids (offers). The process is thus a one-sided auction. 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 company’s Section 12 registered equity shares or units for a limited period of time. throughout which it is assumed they judge whether the pershare price implied by the tender offer meets their personal valuation of said share. At this point. in which the buyer announces a series of bids (although in certain 5 “Tender Offer.sec. However.3 The research behind this paper failed to uncover any theoretical modelling of these empirical findings. it is worth mentioning that the previously cited experimental results refer specifically to oral auctions. 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. Charles Plott conjectures that this behaviour may be a manifestation of ‘counterspeculation’ on behalf of the accepting side: i.” http://www. it is hard to see why ‘counterspeculative’ behaviour should be significantly affected by a shift from oral to other forms of”5 This offer is often conditional on several factors.e. and the market eventually converges on the equilibrium dictated by standard economic theory.htm . When a firm decides to acquire a listed company.

Like the trader subjects in the initial iterations of Smith and Plott’s one-sided oral offer auction. If agents in the market for corporate acquisition behave similarly to the subjects in Smith and Plott’s experiments. There exists a well documented trend of corporate acquisitions “destroying value” for holders of the acquiring company’s stock. and prices increasingly reflect efficient valuations. converges towards equilibrium. Specifically. The opposite effect is observed for shares of the target firm. this should eventually be built into acquirers’ expectations and thus be reflected in a lower willingness to bid. though one would expect it to decrease with the passage of time and number of transactions. then such value destruction should be expected at first. managers at acquiring firms would seem to be making bids above the efficient price of the good being traded. . said trend should decrease as the corporate takeover market matures. Even if there exists some intrinsic characteristic to acquisitions which tends to lead to a decrease in the fundamental value of the acquiring firm’s post-transaction equity. However. as obtained by optimal forecasts employing all available public information. The continuous occurrence of said value destruction can be ultimately pinned on inflated –and thus inefficientbids on behalf of acquiring firms. Basically. Value destruction (creation) for acquiring (target) firms should eventually disappear . That is. such a trend would imply that acquiring firms make bids in excess of the discounted value of the target firm’s estimated future cash flows.4 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. we should not be surprised in finding evidence of an initial trend of takeovers with bids above accurate valuations of the target firms. holders of the acquiring company’s shares suffer a post-acquisition capital loss on the equity they held in the acquiring firm previous to the transaction.

Assuming that capital markets are able to efficiently incorporate public information.5 2. and for the longer period beginning twenty days before the announcement of the deal and ending upon the completion of the transaction. 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. The bulk of these investigations have taken the form of short-window event studies. the following statistics should reflect an unbiased estimate of the expected value . The following table provides some descriptive statistic constructed by Andrade. Mitchell and Stafford using the University of Chicago’s Centre for Research in Security Prices (CRSP) database. concentrating on the behaviour of the involved firms’ stock prices at the time of the transaction announcement. Figure 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.

Erik Stafford. The average abnormal returns are 16% and 24% for the 3 day and 20 day periods. any non-zero percentage change in stock price over the specified periods is considered to be an “abnormal return”. “New Evidence and Perspectives on Mergers. Vol.” The Journal of Economic Perspectives. 103-120. 2001). Vol. Erik Stafford. The implied Although the abnormal returns are negative for both windows – and within all three periods studied. Mark Mitchell. In Smith and 6 Gregor Andrade. that the income distribution is tilted towards the “seller” in these one-way bidder auctions. the data blatantly contradicts this. both are statistically significant at the 1 percent level. No. American Economic Association. 7 Gregor Andrade. the most important finding in the laboratory auctions we are seeking comparison with is the eventual convergence of the market towards equilibrium.6 creation/destruction unleashed by the announced takeovers. respectively. none reach the conventional threshold levels of statistical significance. More importantly. No. relationship for holders of the acquiring firm’s equity is less unambiguous. 15.7 From the statistics. Namely. Nevertheless.. “New Evidence and Perspectives on Mergers.” The Journal of Economic Perspectives. as the abnormal returns for both the acquiring and target firm’s shares are remarkably stable over time (and do not converge to zero). it is clear that holders of the target firm’s stock benefit unequivocally. 3. . 2 (Spring. pp. it would be wise to consider the specificities which differentiate the M&A market from the controlled experiments carried out by Smith and Plott. Unfortunately. 2001). Analysis Before conceding defeat. this perfunctory glance at stock performance for the two counterparties seems to fit in with the first part of our hypothesis. 15.6 Since for the short time periods considered. Mark Mitchell. American Economic Association. Nevertheless. 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”. the expected return of any stock would be approximately zero under any model. pp. 103-120. 2 (Spring.

9 So although economies experience acquisitions on a frequent basis. Consequently. 2001). tremendously expensive and sought out for rather particular reasons. 103-120.were carried out by the same traders. Mark Mitchell. “New Evidence and Perspectives on Mergers. if at all. 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 Plott’s traders is severely impeded.” The Journal of Economic Perspectives. While Smith and Plott’s subjects traded a single good over repeated iterations. the “learning-by-doing” which probably occurs in Smith and Plott’s experimental markets would take a lot longer to occur in the market for M&A. the market for firms is not one bestowed with tremendous liquidity or frequent volumes. Transactions are extremely complex. Mitchell and Stafford shows that M&A activity tends to occur in industry-specific clusters.the subjects acquire trading experience. one may counter that although single firms are not likely to engage in serial acquisitions. 8 . it could easily poach management with M&A experience from Firm B. Vol. 15. often as a response to oneoff exogenous shocks to said industries. American Economic Association. intra-firm labour movements within an industry might facilitate the accumulation of takeover experience within a sector as a whole.7 Plott’s experiments. However. firms often use acquisitions to diversify their business lines. Erik Stafford. empirical work by Andrade. it is important to consider the varying degree to which experience from previous transactions is applicable to future acquisitions. Naturally.8 As is not difficult to imagine. In this sense –and perhaps the main reason behind the remarkably efficient results achieved by the market over time. No. Consider two firms operating in the same sector. Further. Though Firm A may not engage in repeated acquisitions. repeated iterations –or “trading periods”. 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 Plott’s work. 2 (Spring. pp. A flurry of takeovers within a sector is often followed by an extended industry-wide M&A drought. a particular industry may not. 9 Gregor Andrade.

1 (Jan. Vol. A.” Brookings. Frederic M. pp. 74. and those taking over firms with dissimilar business lines (Porter. pp. The lessons learnt in acquiring a telecommunications company may not readily translate into a real estate deal. Given the huge differences in the due diligence and execution of takeovers of business in different industries. Vol. Scherer. 13 Mathew L. The findings of Hayward (2002) study are less clear cut. the degree of uniformity of an acquiring firm’s iterative forays into the takeover market has a considerable effect on the performance of these transactions. highly related acquisitions tend to outperform both sporadic acquirers. 65. 12 D. Several papers imply that corporations undertaking repeated. 2002). Michael E. Strategic Management Journal.C. . “From Competitive Advantage to Corporate Strategy. “What Is Strategy?. 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 Plott’s laboratory markets. Selloffs and Economic Efficiency.43-49. John Wiley & Sons.. 3. 10 11 Michael E. 1987. “Mergers. Ravenscraft and Scherer. 6. Areas for Further Research As the findings of the literature on the determinants of value creation and destruction in acquisitions suggest. Further.8 goods traded for in subsequent iterations might differ vastly. 199611. 23. Vol. one would expect the “learning-by-doing” effect exhibited by Smith and Plott’s subject to be markedly weaker within the wider corporate takeover market. No.” Harvard Business Review.13 4. 198710.” Harvard Business Review.61-78. 21-39. Porter. yet overall acquisition experience having a negative (albeit insignificant) coefficient. Hayward. Washington D. Porter. 198712). Research focusing on the effect of firm characteristics on acquisition performance provides a good deal of evidence to support this caveat. No. “When Do Firms Learn From Their Acquisition Experience? Evidence from 1990-1995”. No. with similarity of previous acquisitions having a positive coefficient on announcement returns. pp.J Ravenscraft.

Subsequently. Mitchell and Stafford’s paper into industry groups. metal mining in the 1990’s or real estate in the 1990’s. A fruitful avenue of research might involve categorizing the takeover announcements studied in Andrade. previous takeover experience. deal financing method. etc. we might be more successful in finding a negative relationship between abnormal returns. 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 1980’s. and industryspecific acquisition experience. 14 Figure 3.). might well remove the noise which could be confounding the statistical findings. Average announcement-period abnormal returns could be computed for the industry subsets in the each of the three time periods.. Restricting the sample of takeovers studied to those in which both the acquirer and target belonged to the same industry . along with better-tailored econometric models. More refined datasets.). See figure 3.9 However. the available data is not sufficient to dismiss the possibility of Smith and Plott’s findings extending to the market for acquisitions. 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. An alternative line of inquiry might consider expanding on Hayward’s organizational learning study.

takeover experience). 5. 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. Similarly.) Most of the literature cited in this paper makes reference to this phenomenon.). Individual takeover announcements could then be grouped by the number of previous acquisitions under the acquirer’s belt. one could develop dummy variables for the different “number of previous acquisition” groups). implying that while acquirers will systematically overpay for target firms. Accordingly. a researcher might still find a decreasing trend and a convergent limit amongst them. This would be consistent with the decelerating trend towards equilibrium exhibited in figure 1. resulting in a fire-sale of the acquiring firms shares. coefficients relating acquisition experience to announcement results could be re-calculated based on this new restricted sample (likewise. Several hypotheses aimed at explaining this recurring occurrence have been conjectured. The announcement of the stock financing of a deal is thus perceived by the market to be a signal of this.10 would greatly increase the extent to which parallels could be drawn between empirical findings in the M&A market and Smith and Plott’s results. 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. there is at least some evidence of positive yet diminishing returns to market interaction (or in our case. Were these co-efficients to still fail to converge to zero (as Smith and Plott’s results would imply). 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. 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 way this equates cognitively into manager’s perception of the firm’s performance might differ from how the very concrete and tangible cost of the drain in a firm’s cash reserves resulting from cash financing does. Additionally. Although the term is most commonly used to describe how the effects of inflation are often ignored when computing monetary returns. although equity issues affect share value directly. this offers a new angle on a well recorded phenomenon which might well be worth exploring. Further. 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. While changes in cash reserves affect the bottom line directly. it could perhaps be applied to management using slacker standards of accounting when computing the real cost of stock financing. 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. Money illusion is defined as the behavioural tendency to use nominal rather than real magnitudes of wealth. . there is no direct link between stock dilution and operating performance. Nevertheless.11 Figure 4.

” The Journal of Economic Perspectives.” The Journal of Economic Perspectives. 15. 15. Mark Mitchell. 103120. pp. Plott. Mark Mitchell. 2 (Spring.” Journal of Economic Literature. American Economic Association. Vol. American Economic Association.. Vol. American Economic Association. Figure 4: Gregor Andrade. • • Figure 3: Gregor Andrade. Erik Stafford. 103120. 2001). Mark Mitchell.” The Journal of Economic Perspectives. Vol. “Industrial Organization Theory and Experimental Economics. No. 15. “New Evidence and Perspectives on Mergers. “New Evidence and Perspectives on Mergers. No. Erik Stafford. 2 (Spring. “New Evidence and Perspectives on Mergers. Figure 2: Gregor Andrade. 2001). • . pp. pp. 2001). 103120. No. No. 1982). Erik Stafford. 4 (Dec. Vol. 2 (Spring. American Economic Association. pp.12 Bibliography for Figures: • Figure 1: Charles R. 1485-1527. 20.