WHICH FIRMS ACQUIRE? DETERMINANTS OF ACQUISITIONS.

• Author: Eminli, Vusal

INTRODUCTION

Finance and economics literature is very rich in mergers and acquisitions (M&A) related research. A great deal of work has been done on the motives of mergers; the debate on the three hypotheses propagated as driving forces behind M&A's--agency, market power and efficiency hypotheses, has not been unanimously resolved yet despite an abundance of work. Research on wealth effects of mergers and acquisitions has been somewhat more conclusive in the sense that most authors have found significantly positive cumulative abnormal returns to target firm shareholders (Moeller, Schlingemann, & Stulz 2004, 2005), while observing zero or negative cumulative abnormal returns to bidding firm shareholders (Betton, Eckbo, & Thorburn 2008).

However, the characteristics of firms involved in M&A deals have been relatively unexplored. Understanding these traits might provide a deeper and more thorough knowledge of merger motives. Additionally, it might also assist investors in identifying potential acquirers and avoiding possible negative cumulative abnormal returns. This paper analyzes the predictors of the probability of being an acquiring firm--a topic strongly related to both strands of the literature.

To this end, a logit regression function is utilized, employing several variables deemed to have an impact on the likelihood of becoming an acquirer, such as firm beta, Tobin's Q, leverage, liquidity, size, earnings, sales, cash flows, and R&D expenditures. For the purpose of this analysis, financial, stock price, and M&A data from 1985 through 2015 is used and year, firm and industry fixed-effects are controlled.

Consistent with the agency and efficiency hypotheses, the results show that Tobin's Q has a significantly negative impact on the probability of being an acquirer, while firm beta, size, earnings, sales, and cash flows are significantly positively related to the aforementioned probability. The results shed light on some of the characteristics of firms engaging in merger activity, more precisely; it provides additional insight into merger motives and allows identifying potential bidders.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

The past century saw five great merger waves--one at its beginning and the subsequent waves at the ends of the 1920s, 1960s, 1980s and 1990s. After these five merger waves and an abundance of data, the motives behind merger activity are not yet clearly understood. The three primary theoretical perspectives that can be used to explain a firm's ambition to acquire other firms, as identified by Montgomery (1994) are the agency theory, the market power argument and the efficiency view.

From the perspective of the agency theory of mergers, managers pursue their personal interests at the expense of other stakeholders in the firm, primarily the shareholders. One of the primary lines of argument under the agency theory umbrella has been advanced by Jensen (1986). Jensen argues that managers have personal incentives in taking decisions that help grow the firm size beyond optimal as growth increases the managers' power by increasing the resources under their control. Jensen further posits that growth is also linked to increases in manager's compensation, arguing that changes in compensation are positively related to growth in sales.

In support of this, Smith and Watts (1992) find that executives of larger corporations have higher levels of compensation. On the contrary, by analyzing the implications of state antitakeover laws on corporate governance, Bertrand and Mullainathan (2003) observe that the average manager in their sample does not lean towards growth. Instead, the authors characterize this average manager by, what they term, "quiet life" models as opposed to empire-building models. Malmendier and Tate (2008), using CEOs' personal over-investment in their own company and their press portrayal as proxies for CEO overconfidence, attempt to explain merger decisions with high self-confidence of the acquiring firm managers. They posit that overconfident CEOs may overestimate their ability to make profitable investments and generate returns. This leads to overpaying for target companies, and in turn, destroys acquiring firm shareholders' value.

The authors find that the likelihood of acquisition is 65% more likely if the manager is classified as overconfident. Shleifer and Vishny (1989) develop a model of managerial entrenchment that illustrates how managers can make specific investment decisions in order to raise their managerial value to shareholders. Through these investments that require the managers' particular skills, managers can extract higher wages and larger perquisites from stockholders, reduce the chances of being replaced, and gain greater liberties in determining corporate strategy.

Amihud and Lev (1981) promulgate another argument in support of the agency theory. It is a well-supported notion that managers are more risk-averse than the shareholders as the latter can better diversify; that is, significant fractions of managers' wealth are tied up to their performance as managers through salaries, reputation, tenure etc. By observing that manager-controlled firms take on a higher number of conglomerate acquisitions than owner-controlled firms, as well as, that manager-controlled firms have more diversified operations, the authors argue that managers utilize mergers in order to reduce their "employment risk" through reducing firm risk, as they lack the sufficient opportunity to diversify in other ways. In subsequent work,

Amihud et al. (1986) claim that such diversification of manager's risk may not necessarily be to the detriment of shareholders; the latter may also benefit from decreased firm risk as they also bear the cost of uncertainty. Contrary to these results, Lewellen et al. (1989) find no tendency of reduced firm-specific risk as a result of merger activities. In fact, the findings show the opposite; the majority of their sample includes acquisitions that, in fact, increase post-merger risk.

The other two competing hypotheses, market power and efficiency, rest on the view that managers of the firms act in the best interest of the owners and maximize shareholder wealth. One way to increase shareholder wealth through a merger, which constitutes the first of these hypotheses, would be by the way of increasing market power. As Stigler puts it, "[c]ollusion of firms can take many forms, of which the most comprehensive is outright merger" (Stigler 1964). The way collusion through merger would increase market power is rather simple: A horizontal merger reduces the number of active firms competing in the same market, makes the actions of each producer more visible and improves the chances of detecting the cheaters on the potential cartel. This, in its turn, by lowering the expected gains from cheating, makes the cartel more profitable. Hence, in the short run, there is an increased incentive to form cartels and, through increased market power, the members of these cartels will earn higher profits.

Yet another potential motive for mergers, which forms the basis of the second competing argument, is that of higher productive efficiency after the merger. This hypothesis follows that after the merger is carried out, the "new" firm will be able to pursue a more cost-efficient production/investment policy, which may be achieved by, among others, economies of scale and/or scope, increases in managerial efficiency, redeployment of assets to more profitable uses, utilization of unused corporate tax credits, and avoiding bankruptcy costs.

One of the most influential studies on the topic in the empirical literature, testing the market power and the efficiency hypotheses, is that by Eckbo (1983). The author analyzes the major horizontal competitors of target firms in order to inspect if mergers lead to collusive behavior. Building upon the market power hypothesis outlined above, the author notes that the rivals that are not part of the cartel are also expected to have increased profitability since they are not bearing the costs of restricting output. If there is some sort of collusion present as a result of a merger, then this should induce changes in relative product prices of rivals.

However, assuming efficient markets, Eckbo further posits that any change in firm profitability due to such movements in product prices will be captured by the financial markets and reflected on the firm value. Then it is possible to test for the existence of collusive behavior (or possibly predict any other outcome of the merger) by observing the abnormal stock returns to the horizontal rivals of merging firms. Eckbo observes that rivals in challenged (by government) mergers almost always earn statistically significant positive abnormal returns around the merger announcement date.

On the other hand, around the antitrust complaint date the stock reactions do reverse; however, the negative abnormal returns around the antitrust complaint date are not statistically significant, while the bidders and targets observe significantly negative abnormal returns around this date. Citing the lack of statistically significant reversion, Eckbo (1983) argues that the market power hypothesis...