Study: Glamour megamergers fall short in the long runWEST LAFAYETTE, Ind. -- Corporate merger mania may pad shareholders' expectations more than their pockets, a Purdue University study finds.
The study defines a glamour company as one to which the stock market assigns a much higher value than the book value of its assets, in other words a company with a high market-to-book ratio. A value company is just the opposite -- its book value is greater than the value of its stock.
"Glamour companies are the blue-eyed boys of Wall Street," says Raghavendra Rau, assistant professor of management at Purdue's Krannert Graduate School of Management. "When their management announces an acquisition, both the market and the management have inflated views of their ability to manage the acquisition. The acquisitions tend to perform badly. Value companies, on the other hand, have performed poorly in the past. Their shareholders are more likely to be prudent in only approving acquisitions that actually create value."
Rau and Theo Vermaelen, a professor of management at INSEAD, a business school in Fontainebleau, France, examined more than 3,100 mergers and nearly 350 tender offers from 1980 to 1991.
A merger is generally a stock-funded "friendly" acquisition that often includes participation by the management of the company being purchased. A tender offer is usually a cash-funded transaction between the acquiring company and the shareholders of the company being purchased. Because tender offers often bypass management, they are more likely to be "hostile" takeovers.
"Our findings are important," Rau says, "because they call into question the long-held assumption that a merger between two corporate stars would boost the value of the stock of the acquiring firm by adding assets. Our research indicates that often the stock of the glamour companies is overvalued by the market, going into the merger, and it simply doesn't perform as well as it would have if the merger had not taken place."
The results of the study indicate that, on average, stock performance for the acquiring company in a glamour merger will be about 17 percent below average over the three years after completion of the deal, compared to the stock of similarly sized companies with similar market-to-book ratios. On the other hand, the stock prices of acquirers involved in value mergers or tender offers ranged from 7.6 to 15.6 percent higher than that of similarly sized companies with similar valuations.
The study finds that some of the underperformance by glamour companies is because many such mergers are stock-financed. Managers who feel that their stock is overvalued by the market will want to use stock to pay for an acquisition rather than cash. Value companies tend to use cash in paying for an acquisition, because they feel that their shares are undervalued. However, this is not the only factor influencing performance, because when the study looks only at cash-financed mergers or tender offers, value acquirers still tend to perform better than glamour acquirers.
The "whys" behind the long-term drop in stock price performance for megamergers are still a mystery and a topic of Rau's continued research. But he speculates that with glamour companies, managers are more likely to overestimate their own performance and their abilities to manage an acquisition. "In many cases, their exuberance is shared by investors who drive the stock prices up when a merger is announced," he says. "The management of value firms, on the other hand, tends to be more prudent. And the market, too, doesn't believe that they will do too well in the acquisition. They tend to underestimate the potential for value creation for such companies.
"We are not saying that mergers will cause shareholders to lose money. But our study has found that after the merger, particularly when the acquirer is overvalued, returns to shareholders may not be as positive as they would have been had the merger not taken place. Shareholders aren't going to go broke in a merger deal, but they shouldn't run out and buy that yacht just yet, either. If they want to keep their wealth growing, they should avoid buying shares of acquirers where the management has been hyped a lot in the press, where the firm has a high market-to-book ratio, and when the acquisition is paid for in stock."
The award-winning study (named "Best of the Best" by the Financial Management Association in 1996) will be published in the August issue of the Journal of Financial Economics. It also has been presented worldwide including presentations to the Yale School of Management, the London Business School and the European Finance Association in Oslo, Norway.
Source: Raghavendra Rau, (765) 494-4488; e-mail, firstname.lastname@example.org
Raghavendra Rau, Purdue assistant professor of management, prepares a chart which
shows that, in the long run, megamergers aren't as profitable as shareholders expect.
(Purdue News Service Photo by David Umberger)