The aim of this project is to examine whether the decision of large UK companies looking to pursue a merger/acquisition strategy will affect shareholder value. The data analyzed in this study will determine if there is a positive or negative correlation in shareholder wealth when a merger/acquisition occurs.
The research for this project will be conducted through the analysis of 40 different large UK companies that were merged or acquired by other UK based firms prior to 2002. The data will be obtained from the Bloomberg website. Further research and analysis on the topic will include information obtained from books, journals and reliable internet sources. To test the value of shareholder wealth when a merger/acquisition is pursued, different models will be used which includes Capital Asset Pricing Model, Efficient Capital Markets, Equilibrium Models, and Market Model (Event Studies and Abnormal Returns Methodology). The hypothesis that will be tested in this study is:
H0 = If managers of large sized UK companies pursue a merger and acquisition strategy then shareholder wealth (value) will increase.
H1 = If managers of large sized UK companies pursue a merger and acquisition strategy then shareholder wealth (value) will remain unchanged or will decrease.
The first chapter will give a brief overview of mergers and acquisitions and introduce the reader to recent merger trends in the UK and different types of takeovers. The second chapter will be an in-depth analysis of past research studies which includes: examining different ways a company pays for a bid in a merger, exploring shareholder and managerial wealth perspectives, and analyzing long term post-merger performance of target and bidder firms. Chapter three presents the research methodology used in wealth gain studies and also states the methodology adopted for this dissertation. Chapter four analyzes and discusses the findings in context to wealth gain effects of mergers and acquisitions among the large UK companies chosen for this study. Chapter five concludes this research and highlights possible areas that may require further investigation.
Mergers and acquisitions have become important events in today’s rapidly changing business environment and have been the subject of many research studies. Reasons as to why companies may pursue a merger or acquisition strategy could be to reduce costs to achieve economies of scale or to reduce competition due to increased market power. Mergers and acquisitions have also been known to facilitate entry into new markets or industries and increase the level of effectiveness in a company by eliminating inefficient management. Mergers and acquisitions worldwide have tended to follow a pattern of waves, with there being periods of frantic takeover activity followed by relatively calmer periods.
The main objective of financial theory is to maximize shareholder wealth therefore all decisions are taken with the aim of maximizing shareholder value. The purpose of this research is to re-examine the shareholder wealth gain criterion with regards to mergers and acquisitions within the United Kingdom. The objective of this study is to find out if shareholders of large UK companies benefit from the acquisition decisions made by the managers. Past research studies on post-acquisition performance of acquiring and target firms have mixed results. To determine if there is an increase or decrease in shareholder value from corporate takeovers, the Market Model and Event Study Methodology will be used in this study.
The hypothesis developed in this study aims to support the argument that mergers and acquisitions are profitable events and lead to an increase in shareholder value. This study however concluded that merger and acquisitions among the large UK organizations chosen did not lead to an increase of shareholder value for both target and bidder firms. These results might not be entirely accurate due to various reasons such as size effects and the firms chosen in this study are from different industries. Other factors such as acquisition financing and acquisition motives also may have an effect on shareholder value however the testing of these factors is outside the scope of the following study.
CHAPTER 1: OVERVIEW OF MERGERS AND ACQUISTIONS
The following chapter briefly examines the benefits that a merger is expected to generate for both the target firm and the acquiring firm. The historical pattern of takeover activity in the UK from 1964-1992 is discussed to show merger and acquisition (M&A) trends and recent M&A activity abroad and within the UK will also be highlighted among large UK companies in 2008. In addition, the definition of mergers and acquisitions is provided and the second part of chapter one introduces the reader to different types of mergers used to create value for an organization.
1.1 Benefits to Mergers and Acquisitions Activity
The main objective for an acquiring firm is to grow and expand its assets, sales and market shares. Other specific reasons for entering into a merger bid are reflected in the benefits that are expected to be generated which include:
- Exploiting scale economies
- Obtain synergy
- Enter into new markets
- To restore growth impetus
- To acquire market power
To reduce dependence on existing or perhaps risky activities
With the above mentioned benefits to M&A activity, it should also be noted that takeovers most likely to succeed are those approached with a strategic focus, incorporating a detailed analysis of the objectives of the takeover, the possible alternatives and how the acquired company can be integrated in the new parent (Pike and Neale).
1.2 Trends in UK Merger Activity
There has been an increasing trend of M&A activity in the UK over the past few decades, with there being periods of high takeover activity followed by relatively slower periods as can be seen by the graph below.
Figure 1.0 History of UK M&A Activity
Source: National Statistics, 2002
The highest peaks in takeovers are during the period 1984-1989. During this time, the average size of an acquisition had grown significantly from 9.64 million to 20.38 million. As per Sudarsanam (1995) the main reason for this was because the stock market in the UK, along with the harmony with the rest of the world stock markets experienced a strong bull phase which culminated in the October 1987 crash. Furthermore, the 1980s’ also experienced divestments on a large scale which meant companies would sell off divisions or subsidiaries to other firms of the divested parts in a management buyout. This increase in acquisitions and divestments had shown significant amount of corporate restructuring in the UK and thus led to new organizational innovations such as management buyouts and management buyins, as well as by financial innovations like high-leverage buyouts and mezzanine finance (Sudarsanam, 1995).As can be seen from the graph above, the UK M&A market has experienced a relatively leaner period, which has continued till date. The main reasons that can be attributed to this are the various world catastrophes and the overall global economic slowdown.
As per the office of National Statistics, the largest significant transaction recorded during the first quarter of 2008 was the acquisition by Imperial Tobacco Group Plc of Altadis S.A. for a press reported value of 9.3 billion. Another significant transaction was the acquisition by Carillion Plc of Alfred McAlpine Plc for a reported value of approximately 0.5 billion. For quarter one in 2008, the number of transactions reported for acquisitions in the UK by UK companies has been the lowest reported since quarter one 2003.
Other recent major UK mergers & acquisitions (2008) are as follows:
Value in million
|Carillion Plc acquiring Alfred McAlpine Plc||554|
|Willmott Dixon Ltd acquiring Inspace Plc||133|
|easyJet Plc acquiring GB Airways Ltd||104|
|iimia MitonOptimal Plc acquiring Midas Capital Partners Ltd||100|
Source: National Statistics, 2008
Table 2.0 Recent Acquisitions abroad by UK Companies
Value in million
|Imperial Tobacco Group Plc acquiring Altadis S.A.||9339|
|Reckitt Benckiser Group Plc acquiring Adams Respiratory Therapeutics||1100|
|Scottish and Southern Energy Plc acquiring Airtricity Holdings Ltd||808|
|SABMiller Plc acquiring Koninklijke Grolsch N.V||606|
|Ineos Group Ltd acquiring Kerling AS 429||429|
|Standard Chartered Plc acquiring American Express Bank Ltd||413|
|Kesa Electricals Plc disposing of BUT SAS||389|
Source: National Statistics, 2008
1.3 Definitions and Different Types of Mergers and Acquisitions
Although the terms ‘merger,’ ‘acquisition’ and ‘takeover’ are used interchangeably, technical differences do exist. A merger is when corporations come together to combine and share their resources to achieve a common set of objectives (Sudarsanam, 1995). The shareholders of the two combined corporations will continue to be joint owners. An acquisition is when one firm purchases the assets or shares of another firm however the shareholders of the acquired firm continue being owners of that firm. A takeover is the acquisition by one company of the share capital of another in exchange for cash, ordinary shares, loan stock or a combination of these (Pike and Neale). This distinction between the three terms is important in certain contexts however they are used by researchers’ and authors’ interchangeably. In the following dissertation, I too will use these three terms interchangeably.
There are different types of mergers that exist to create value and are classified into three main categories: horizontal, vertical and conglomerate (Pike and Neale).
Horizontal integration: this is when a company takes over the target firm from the same industry and at the same stage of the production process.
Vertical integration: where the target is in the same industry as the acquirer however is operating at a different stage in the production process. This can be either close to the source of materials (backward integration) or close to the final customer (forward integration).
Conglomerate integration: occurs when the target is in a business that is different to the acquirer. The reasons a firm may undergo a conglomerate merger is to reduce risk through diversification, opportunities for cost reduction and improving internal and external efficiencies.
In order to understand whether mergers and acquisitions create or destroy shareholder value, it is important to appreciate and understand few critical aspects of the complex M&A theory. The three areas in helping to answer this question with respects to the impact of shareholder value in my opinion are different modes of financing mergers and acquisitions, motives for M&A activity and post-merger performance. Various researchers in the finance field have conducted a great amount of research on the above mentioned areas and this dissertation will help put into perspective mergers and acquisitions impact on shareholder value currently in the UK.
CHAPTER 2: BACKGROUND OF STUDY
Mergers and acquisitions are undertaken as a means of corporate growth and expansion but are also an alternative to growth through internal or organic capital investment. The immediate objective of an acquisition is self-evidently growth and expansion of the acquirer’s assets, sales and market share (Sudarsanam, 1995). Another objective of acquisitions would be to increase the growth of shareholders wealth aimed at creating a strong competitive advantage for the acquirer. In modern finance theory, shareholder wealth maximization is a strong rational for financing and investment decisions made by management. This leads to the question of wealth gain effects of mergers and acquisitions, specifically among large UK companies. The following chapter introduces various literature regarding wealth gain effects of mergers and acquisitions and highlights the various aspects of mergers and acquisitions which may have an effect on the shareholder value within large UK corporations.
2.1 Modes of Acquisition Financing
There are various modes of financing a takeover which includes: cash (preferred method), issuing of ordinary shares and fixed interest securities (loan stock, convertibles, and preference shares). The way in which a merger and acquisition is financed has different benefits to the target shareholders and bidder shareholders. In addition, cash takeovers may be sufficiently different from non-cash acquisitions and failure to distinguish between them may lead to inappropriate generalizations (Carleton et al, 1983). As per Sudarsanam (1995), there are various ways a firm can bid an acquisition, which is shown in Table 3.0.
Table 3.0 Bid Financing
|Bidder Offers||Target shareholders receive|
|Cash||Cash in exchange for their shares|
|Share Exchange||A specified number of bidder ‘s shares for each target share|
|Cash underwritten share offer (vendor placing)||Bidder’s shares, then sell them to a merchant bank for cash|
|Loan stock||A loan stock/debenture in exchange for their shares|
|Convertible loan or preferred shares||Loan stock or preferred shares convertible into ordinary shares at a predetermined conversion rate over a specified period|
|Deferred payment||Part of consideration after a specified period, subject to performance criteria|
Source: Sudarsanam (1995, p.177)
In addition, a bidder making cash offer can finance it from one or more of the following sources (Sudarsanam, 1995):
Internal operating cash flow
A pre-bid rights issue
A cash underwritten offer, e.g. vendor placing or vendor rights
A pre-bid loan stock issue
A cash offer has two advantages from the point of view to both the target and acquiring shareholders which includes (Pike & Neale, 1999):
The amount is certain; there is no exposure to the risk of adverse movement in share price during the course of the bid.
The targeted shareholder is more easily able to adjust his or her portfolio than if he or she receives shares, which involve dealing costs when sold. Because no new shares are issued, there is no dilution of earnings or change in the balance of control of the bidder.
In terms of shares being used as a medium of exchange again there are some advantages to both target as well as acquiring shareholders (Arnold, 2002) which are:
For target shareholders use of shares helps avoid capital gains tax.
Target shareholders maintain an interest in the combine entity thus helping preserve as well as increase shareholders value.
Acquiring shareholders gain from the fact that there is no immediate cash outflow.
Nickolaos Travlos (1987) study titled Corporate Takeover Bids, Method of Payment, and Bidding Firms’ Stock Returns was to examine the role of the method of payment in determining common stock returns of bidding firms at the announcement of takeover bids. The analysis in the study was to show the valuation effects on two common methods of payment which are common stock exchanges and cash offers. The results showed that bidding firms had normal returns in cash offers however experienced significant losses in pure stock exchange acquisitions. Other literature studied by Asquith and Mullins (1986), Kalay and Shimrat (1987), Masulis and Korwar (1986) and Mikkelson and Partch ( 1986) show that common stock issues have negative stock price when there are new common stock offerings. These results were supported by various other studies such as Henri Servaes’s (1991) study titled Tobin’s Q and gains from takeovers. Agrawal, Jaffe and Mandelkar (1992) found post-acquisition returns to be lower for share-financed acquisitions in comparison to cash-financed acquisitions. They further went on to prove that shareholders of acquiring firms suffered a statistically significant loss of about 10% over the five-year merger period.
The bidding firm’s method of payment provides valuable insight to the market. If the bidding firm’s managers possess information about the intrinsic value of their firm, independent of the acquisition, which is not fully reflected in the pre-acquisition stock price, they will finance the acquisition in the most profitable way for the existing stockholders (Travlos, 1987). Myers and Majluf (1984) model states that management will prefer cash offerings if they believe their firm is under-valued however a common stock exchange offer will be preferred if they believe their firm is over-valued. In addition, market participants will strongly favor a cash offer as good news while the opposite holds true for a common stock exchange about the bidding firm’s true value. If such information is important in the market, then the bidding firm’s stock price change at the proposal’s announcement will reflect both the gain from the takeover (weighted by the probability that the takeover bid will go through) and the information effects (Nickolaos, 1987). Jensen and Ruback (1983) state that most tender offers are financed by cash however merger proposals are financed by the exchange of common stock therefore the information argument states that larger target residuals occur in tender offers rather than in mergers. In their study conducted, they determined that for mergers, the weighted abnormal target firm return is 16.3% over the month before announcement however for tender offers; the weighted target return is 30.9% over the two-month period surrounding the announcement dates.
Cash is by far the most widely used form of payment in mergers and acquisitions. There are many reasons as to why there is an increased use of cash in financing mergers. One possible explanation for the increasing use of cash depends on market imperfections and/or agency considerations (Carleton et al, 1983). Another reason for why bidding firms use cash in financing mergers is the increase in the number of hostile mergers. Cash not only signals a high value for the target, but also preempts other firms from bidding (Martin, 1996). These findings were also found in the literature of Eckbo, Giammarino and Heinkel (1990) which include a role for mixed financings in which higher-valued bidders are more likely to use more cash to finance the acquisition.
As can be seen from the literature above the mode of payment in an acquisition may be driven by various motives and can have various effects on the bidders and acquirers stock price. This can have a major impact on shareholder value during corporate acquisitions as well as value gain studies. A study by Loughran and Vijh (1997) formed an association between the mode of acquisition (merger and tender offer) and the method of payment (cash or stock). They studied this relationship in the context of wealth gains from acquisitions and concluded that the post-acquisition returns of acquirers are related to both the mode of acquisition as well as form of payment. This was also proved by various other researchers (mentioned above) thus making the method of payment during an acquisition all the more important. Reason being, post-acquisition returns are what tend to effect shareholder value the most therefore the knowledge and distinction of the various modes of financing an acquisition is very relevant and essential.
2.2 Motives for Mergers & Acquisitions – A Dual Perspective
Tender offers allow for an in-depth analysis of agency relationships since the best interests of the principal (target firm shareholders) and agent (target firm managers) are often in conflict. Managers of the target firm are often in conflict of interest between their fiduciary responsibilities to the shareholders and their own personal wealth. For this reason, tender offers allow for the analysis of agency conflicts between shareholders and management of the target firm.
According to Sudarsanam (1995) there are two main perspectives for acquisition motives which are:
Shareholder wealth maximization perspective
Under the shareholder wealth maximization perspective, all firms’ decisions including acquisitions are made with the objective of maximizing the wealth of the shareholders of the firm. In mergers and acquisitions, management of the target firm will oppose bidding firms to takeover if they believe this action would not be in the best interest of its shareholders. Target managers that oppose a bid defend their reasoning by claiming that the bid price is not adequate enough.
Managerial wealth perspective
Under the managerial wealth perspective, target managers may face an uneasy choice between obligations to current shareholders and those who aspire to such a position (Walkling and Long, 1984). For many target managers, if they sense a possibility of a loss in compensation from the merger or acquisition, conflict of interest will then increase. If self interest is pursued by target managers, there is a possibility that a bad acquisition may occur and/or a loss of shareholder wealth.
According to Sudarsanam (1995), managers may undertake acquisitions for the following reasons:
To pursue growth in size of their firm, since their salary, prerequisites, status and power are a function of firm size. (Empire-building syndrome)
In order to deploy their currently underused managerial skills. (self-fulfillment motive)
To diversify risk and minimize costs of financial distress and bankruptcy. (job security motive)
To avoid being taken over. (job security motive)
The managerial wealth perspective motive is one of survival. Not only do managers tend to seek motivation from sustained growth but also seek job security. Managers unlike shareholders cannot diversify to spread their risks since they are tied to one company. If that company is acquired, managers have a high probability of losing their jobs. A study conducted by Firth (1991) tests to see if executive reward increases when an acquisition takes place. In a sample of 254 UK takeover offers during 1974-1980 found that the acquisition process leads to an increase in managerial remuneration, and that this is predicated on the increased size of the acquirer and concludes that the evidence is ‘consistent with takeovers being motivated by managers wanting to maximize their own welfare'(Firth, 1991).
Agency conflicts arise whenever differing incentives cause managers to take actions that benefit themselves but harm shareholders. In the context of acquisitions, agency conflicts may lead to a reduction in shareholder wealth if managers pursue expansion for nonprofit-maximizing reasons. According to past literature, large target shareholder wealth gains are experienced during the announcement of a takeover and large shareholder wealth losses occur when a takeover bid fails (Jensen and Ruback, 1983). This implies that target management interests are not always achieved by accepting bid offers. In addition, target managers may lose compensation and other perks if they are replaced after a successful bid offer. These findings are also confirmed by Walkling and Long (1984) and Martin and McConnell (1991), all of whom reported above-average managerial turnover after a successful takeover bid. The study findings show that in addition to lost compensation, managerial turnover may also be associated with loss of status. Martin and McConnell (1991) further go on to say that the mergers and acquisitions market plays an important role in controlling the non-value maximizing behavior of managers of large corporations.
As shown from the literature above, the shareholder wealth perspective and managerial wealth perspective may conflict with one another. With respects to mergers and acquisitions, the managerial motives and a manger’s reaction to a takeover bid may have an impact on the shareholder wealth maximization criterion. The extent to which it would impact shareholder value will be decided by the amount of control managers’ have within the organization.
2.3 Post Merger Performance Debate (Targets and Bidders)
There has been considerable interest in the post merger performance on shareholders returns in the target and bidder firms. Typical findings by researchers show three patterns: (1) target shareholders earn significantly positive abnormal returns from all acquisitions, (2) acquiring shareholders earn little or no abnormal returns from tender offers and (3) acquiring shareholders earn negative abnormal returns from mergers. Overall, the results of post merger performance have been mixed.
According to Langetieg (1978) and Asquith (1983), their research concluded that acquired firms experience significantly negative abnormal returns over one to three years after the merger. In the research study conducted by Agrawal, Jaffe and Mandelker (1992) titled The Post-Merger Performance of Acquiring Firms: A Re-examination of an Anomaly found that stockholders of acquiring firms experience a statistically significant wealth loss of approximately 10% over five years after the merger completion date.
Research conducted by Franks, Harris and Titman (1991) found that no significant underperformance of stockholders returns exist over a three year period after the acquisition. Franks et al concluded that the previous findings of poor performance post-acquisition were likely to be due to benchmark errors rather than inconsistencies with the Efficient Market Theory (EMH) or mis-pricing at the time of the takeover. Similar results that underperformance of stockholders returns do not exist over a three year period after acquisition is also concluded by Bradley and Jarrell (1988).
A few studies have analyzed value gains during merger and acquisitions with respect to various classes of merging firm’s security holders. A study was carried out by Dennis and McConnell (1986) namely, Corporate Mergers and Security Returns and their results indicated mergers on average to be value creating activities for the acquired and the acquiring company individually. They found by other previous studies that on average common stockholders of acquiring firms earn positive returns but are usually not statistically significant. Their results also indicated that convertible preferred stockholders (of acquiring firm) received positive and statistically significant returns post-merger; however, non-convertible preferred stockholders received positive but not statistically significant returns post-merger. The combination of the above mentioned results lead to an overall increase in the value of the firm therefore presenting us with the reason as to why corporations go ahead with mergers which do not earn statistically significant returns to common stockholders of the acquiring firms’. Research results by Asquith and Kim (1982) also confirm what other investigators found for mergers: abnormal returns to the common stocks of acquired firms are positive and statistically significant; abnormal returns to the common stock of acquiring firms are not significantly different from zero.
In the study Do Long-term Shareholders Benefit Corporate Acquisitions? by Loughran and Vijh (1997), found that post acquisition returns of acquirer’s stock are related to both the form of payment as well as the mode of acquisition. They concluded in the overall sample of 947 cases, acquirers that make merger bids earn, on average, 15.9 percent less than matching firms whereas acquirers that make tender offers earn 43.0 percent more than matching firms during a five-year period after acquisition. In addition, stock acquirers earned 24.2 percent less however cash acquirers earn 18.5 percent more with respects to matching firms. Furthermore, conclusions show that during a five year period following the acquisition, on average, firms t