Cash-rich Acquirers Do Not Make Bad Acquisitions: New Evidence 1

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1 Cash-rich Acquirers Do Not Make Bad Acquisitions: New Evidence 1 Ning Gao a,2 and Abdulkadir Mohamed b a University of Manchester, Alliance Manchester Business School, Manchester Accounting and Finance Group, Booth Street East, M13 9SS, U.K. ning.gao@mbs.ac.uk. b Cranfield University, School of Management, Bedfordshire, MK43 0AL, U.K. abdulkadir.mohamed@cranfield.ac.uk Abstract Cash-rich acquirers perform better than their cash-poor counterparts in the presence of financial constraints, strong shareholder rights or both. This observation holds for both short and long term, for both the U.S. and the U.K, and for different measures of financial constraints and shareholder rights. Cash-rich acquirers underperform only when they are less financially constrained and their shareholders have weak rights. This result demonstrates that cash richness is value-enhancing when internal and external governance arrangements are appropriate. The positive cash holdings effect on acquirer performance can be explained by the precautionary motive. Key words: cash holdings; acquirer performance; financial constraints; shareholder rights; mergers and acquisitions. JEL Classification: G34, G30 1 We thank Kevin Aretz, Heitor Almeida, Paul André, Sanjay Banerji, Onur Bayar, Mike Bowe, Michael Brennan, Francis Breedon, Murillo Campello, Gary Cook, Murray Dalziel, Viet Dang, Sudipto Dasgupta, David Denis, Elizer Fitch, Chris Florackis, Laurent Frésard, Ian Garrett, Alfonsina Iona, Weimin Liu, Evgeny Lyandres, Maria Marchica, Aydin Ozkan, Neslihan Ozkan, Jay Ritter, Konstantinos Stathopoulos, Ronald Masulis, Christos Mavis, Ser-Huang Poon, Norman Strong, Richard Taffler, Martin Walker, and Huainan Zhao. We also thank the seminar participants at Durham University, University of Nottingham, University of Nottingham (Ning Bo), University of Manchester, University of Liverpool, Queen Mary University of London, and Zhejiang University, as well as the participants of the FMA 2012 annual conference in Atlanta, the ESRC Conference on Corporate Governance and Corporate Investment 2011, the European Financial Management Association (EFMA) 2011 conference, and the British Accounting and Finance Association Northern Area Group Annual Conference All errors are ours. We gratefully acknowledge the support of ESRC Grant RES Manchester Accounting and Finance Group, Alliance Manchester Business School, University of Manchester, Booth Street East, M13 9SS, U.K. ning.gao@mbs.ac.uk, Tel: +44 (0) , Fax: +44 (0)

2 Cash-rich Acquirers Do Not Make Bad Acquisitions: New Evidence Abstract Cash-rich acquirers perform better than their cash-poor counterparts in the presence of financial constraints, strong shareholder rights or both. This observation holds for both short and long term, for both the U.S. and the U.K, and for different measures of financial constraints and shareholder rights. Cash-rich acquirers underperform only when they are less financially constrained and their shareholders have weak rights. This result demonstrates that cash richness is value-enhancing when internal and external governance arrangements are appropriate. The positive cash holdings effect on acquirer performance can be explained by the precautionary motive. Key words: cash holdings; acquirer performance; financial constraints; shareholder rights; mergers and acquisitions. JEL Classification: G34, G30

3 In his paper, we examine how financial constraints and shareholder rights alter the relation between acquirers cash holdings and merger performance. That cash-rich companies make value-destroying acquisitions constitutes frequently cited evidence of the agency theory of free cash flow (Jensen, 1986). The prominence of cash-rich acquirers poor performance as evidence of the agency cost of free cash flow is owing to the fact that acquisitions are among the largest and most visible types of corporate investments and represent a most important channel of value creation or destruction. In the same paper, however, Jensen suggests that financially constrained companies are less subject to this agency concern (Jensen, 1986, p324), because these companies are inevitably under the discipline of external capital markets. Nevertheless, extant empirical literature on merger performance is silent about this qualification. Moreover, although recent literature suggests that weak shareholder rights reduce acquirer returns (Masulis, Wang, and Xie, 2007; Harford, Humphery-Jenner, and Powell, 2012), little has been done to examine whether or not strong shareholder rights can channel company cash holdings towards efficient acquisitions. A priori, the value implication of company cash holdings can either be positive or negative. On the one hand, cash holdings offer financial flexibility that permits financially constrained companies to capture valuable investment opportunities as they arise (Myers and Majluf, 1984; Keynes, 1936; Almeida, Campello, and Weisbach, 2004); on the other, excessive cash holdings lead to agency costs (Jensen, 1986; Stulz, 1990). Indeed, previous studies provide mixed evidence about the net benefit or cost of corporate cash holdings to shareholders. For example, while Mikkelson and Partch (2003) find excessive cash holdings do not inflict agency costs, Harford (1999), Lang, Stulz, and Walkling (1991) and Oler (2008) demonstrate high cash holdings can be a concern for acquirer shareholders. These mixed predictions and findings suggest that the efficiency of acquisitions by cash-rich acquirers should be conditioned upon factors determining management motive and the degree of agency cost. In this paper, we provide new evidence on cash-rich acquirers performance using updated data and samples from both the U.S. and the U.K. We demonstrate that, in the presence of 1

4 financial constraints and/or strong firm-level shareholder rights, cash-rich acquirers perform better both at deal announcements and in the long run after deal completion. 1 Cash-rich acquirers underperform only when they are less financially constrained and have weak shareholder rights. On average, cash-rich acquirers also outperform. This result is robust to alternative measures of financial constraints, shareholder rights and cash holdings. We are also able to replicate this result in the different institutional context of U.K. Rationalizing the positive impact of acquirer cash holdings on performance requires a mechanism more than the mere absence of agency costs. In other words, the absence of agency cost does not automatically imply a positive relation. We postulate that, in the presence of financial constraints and/or strong shareholder rights, managers are more likely to hold cash for the precautionary motive than for private benefits. Here, we briefly describe the mechanism through which the precautionary motive predicts better performance of cash-rich acquirers. A more detailed explanation is in Appendix C. Almeida, Campello, and Weisbach (2004) formalize the precautionary motive, which can be traced back to Keynes (1936). 2 Simply put, the precautionary motive postulates that the manager of a financially constrained firm may forgo current investment and reserve cash to invest in future projects that are more profitable. In their model, the manager of a financially constrained firm trades off current and future projects. She saves cash out of current cash flows if a future project is expected to be more valuable than the current one. Cash holdings are optimized when the expected marginal return of the future project equals the expected marginal return of the current one. Consequently, a financially constrained firm holds more cash today if the manager believes that the future project is more profitable, ceteris paribus. Therefore, ceteris paribus, a cash-rich firm foresees more valuable projects in the future compared to a cash-poor firm. Stock 1 Several influential studies examine shareholder rights at the country level, e.g., La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998), which is not our focus of analysis. 2 Terminology is not unified in the previous literature (see Kim, Mauer, and Sherman, 1998, p336). In this paper, we adopt the definition of Almeida, Campello, and Weisbach (2004), as well as Han and Qiu (2007), which focuses on the trade-off between current and future projects. 2

5 prices prior to an acquisition should have incorporated such an expectation; however, an update to the acquisition probability induces greater announcement returns for cash-richer acquirers. To establish this idea, assume that acquisition is the only type of future investment. Let E(V H ) denote the expected value of an acquisition available to a cash-rich company H, and let E(V L ) denote the expected value of an acquisition available to a cash-poor company L. According to the precautionary motive, E(V H ) > E(V L ) if the concavity of the production function is constant (Appendix C provides a more detailed discussion). Assume that both acquisitions are anticipated equally by the market with probability p < 1. At deal announcement, the return to company H should be higher than the return to company L, i.e., (1 p) E(V H ) > (1 p) E(V L ). Note that our hypothesis is not based on the cash flow sensitivity of cash proposed by Almeida et al. (2004) but builds on their analysis of how the value of a future project relates to optimal cash holdings. In the U.S., shareholder rights vary substantially at firm level (Cremers and Ferrell, 2014). We use the E-index (the entrenchment index developed by Bebchuk, Cohen, and Ferrell, 2009) and CEO duality (Brickley, Coles, and Jarrell, 1997; Rechner and Dalton, 1991; Baliga, Moyer, and Rao, 1996; Masulis, Wang, and Xie, 2007) to measure the extent to which managers are exposed to the discipline of corporate control market and the oversight of shareholders respectively. 3 We use the terms combined and separated leadership rather than CEO duality to facilitate our subsequent discussions. As is already mentioned, we document a positive association between acquirers cash holdings and their performance in both the short and long term for those U.S. acquirers with strong shareholder rights (using low E-index values or separated leadership structures as proxy). We show that the positive effect at deal announcement emerges when a transaction surprises the market (Appendix D explains how we classify predicted and unpredicted acquirers), which is consistent with the view that the update of acquisition probability produces differing announcement returns for cash-rich and cash-poor acquirers. In the U.K., on average, acquirer cash holdings have a positive effect on acquirer 3 Using the G-index of Gompers, Ishii, and Metrick (2003) yields similar results. The E-index summarizes the six most essential elements of the G-index (Bebchuk, Cohen, and Ferrell, 2009). Moreover, RiskMetrics does not provide all the data needed to calculate the G-index for years after

6 performance, and it is more pronounced under stronger shareholder rights (measured by nontrivial institutional holdings). The U.K. market is particularly relevant in checking the validity of our observations in a different institutional environment. Although these two countries are similar in several dimensions of shareholder rights (La Porta, Lopez-De-Silanes, Shleifer, and Vishny, 1997), a closer examination reveals that, on a number of important dimensions, U.K. institutions give more rights to shareholders than U.S. institutions (In Appendix A, we explain the U.K. institutional context in greater detail). Several influential studies postulate that shareholder rights are particularly strong in the U.K. due to its legal, regulatory, and cultural institutions (Black, 1990; Black and Coffee, 1994; Bebchuk, 2005; Armour and Skeel, 2007). Bebchuk (2005) further argues that the U.S. is exceptional among developed economies in that its institutions empower managers excessively. A few previous studies also demonstrate that, compared to U.S. institutions, U.K. institutions offer minority shareholders better protection from self-dealing (Djankov, La Porta, Lopez-de-Silanes, Shleifer, 2008) and provide incumbent shareholders better protection from disruptive takeovers (Nenova, 2006). Strong shareholder rights in the U.K. are exemplified by the high-profile takeover of Cadbury by Kraft in Despite objections from Cadbury management, the deal was completed without much difficulty. As is noted in an article published by the New York Times, If the takeover battle were happening in the United States, it would most likely be a fierce fight The potential for a CEO or entrenched board to block a deal or otherwise act in its own self-interest is virtually nil. In other words, England (U.K.) is as close as any country gets to a true shareholder democracy. Any bid gets put to a vote, and all the board can do is to offer an opinion November 17, 2009, New York Times. 4 Therefore, the U.K. institution arguably offers stronger shareholder rights than the U.S. institution, which explains cash-rich acquirers on-average superior performance in the U.K. Consistent with the view that the precautionary motive is particularly relevant when a firm is more financially constrained, we find that the positive cash holdings effect is particularly 4 In Appendix A, we explain the U.K. institutional context in more detail. 4

7 obvious when acquirers have high Whited-Wu indices (Whited and Wu, 2006) or have never obtained a bond rating (Whited, 1992; Almeida et al., 2004; Denis and Sibilkov, 2010; Duchin, 2010), regardless of the acquirer s country of domicile. 5 The Whited-Wu index captures a wide range of firm characteristics that relate to financial constraints. The use of bond ratings is motivated by several theoretical studies that examine how information asymmetry in the bond market affects a firm s access to external financing (Myers, 1977; Jensen and Meckling, 1976; Whited, 1992). We define a No bond ratings dummy to capture such information asymmetry (1 if an acquirer has never obtained a bond rating and 0 otherwise), following previous studies (Almeida et al., 2004; Denis and Sibilkov, 2009; Duchin, 2010; Harford and Uysal, 2014). We further find that, when acquirers are more financially constrained, the negative cash holdings effect disappears, even under weak shareholder rights (i.e., combined leadership or high E-index). In all regressions estimating acquirer announcement returns, we control for the estimate of acquisition probability to ensure that the return difference between acquirers of different levels of cash holdings are not driven by the extent of market anticipation. To ensure our results are not driven by the self-selection of acquirer sample, we estimate a Heckman (1979) model (not tabulated) and show that our results are robust to self-selection bias. Another plausible concern about our U.K. results is that the positive cash holdings effect is due to unmeasured institutional differences between the U.K. and the U.S. To the extent that these two countries have similar legal origins, financial market developments, and dispersed company shareholder bases, this concern is substantially mitigated. To be sure, we further show that the positive cash holdings effect is more pronounced in the presence of nontrivial institutional shareholdings in acquirers, which is true both in the short term and in the long term. Under the precautionary motive, cash holdings reflect managers view of a company s future growth opportunities relative to current investments (Almeida et al., 2004). To measure the level of cash holdings, we use the excess cash holdings estimated following Opler, Pinkowitz, Stulz, and Williamson 5 We estimate Whited-Wu indexes for the U.S. and the U.K. using data in each country. 5

8 (1999). But our results are robust to several alternative measures of excess cash holdings (Appendix B provides more details). Our study emphasizes the importance of financial constraints and shareholder rights in ensuring cash-rich companies making efficient acquisitions. As Jensen (1986) postulates, agency concerns are less likely to strike if companies have to rely on external capital markets for financing. In such circumstances, external capital markets can discipline companies and internal cash is more likely to be held due to the precautionary motive. Indeed, Faulkender and Wang (2006) and Pinkowitz and Williamson (2007) demonstrate that the value of cash holdings increases with the degree of financial constraints; Denis and Sibilkov (2009) find that cash holdings facilitate investments made by financially constrained firms. Our result that cash-rich acquirers perform better is in line with the view of these studies. Our study also agrees with a broad observation that strong corporate governance and investor protection are associated with greater value of cash (Dittmar and Mahrt-Smith, 2007; Pinkowitz, Stulz, and Williamson, 2006). A closely related study is by Masulis, Wang, and Xie (2007) who find that stronger corporate governance relates to greater acquisition efficiency. Our study is different, however, in that we particularly ask how cash richness relates to acquirer performance. The theoretical foundation of our study is not only the agency theory but also the precautionary motive. Harford, Mansi, and Maxwell (2008) report that weakly governed companies deploy cash quickly through investing in acquisitions or capital expenditures, and cash holdings negatively relates to company value and profitability. Consistent with their broad observation, we explicitly demonstrate that acquirer cash holdings are value-enhancing under strong shareholder rights. Our study also extends the original analysis of Harford (1999), by demonstrating that cash-rich acquirers underperform only when they are less financial constrained and have weak shareholder rights. Harford s (1999) analysis covers a sample period in the U.S. from 1976 to We analyzes a more recent period from 1984 to 2012 during which market participants in the U.S. saw substantial increase in the importance and awareness of shareholder rights (Bebchuk, Cohen, and Wang, 2013; Cremers and Ferrell, 2014) as well as enhanced relevance of the precautionary motive for corporate cash 6

9 holdings (Bates, Kahle, and Stulz, 2009). 6 Our evidence from the U.K., a regime that arguably offers shareholders stronger rights, further confirms the presence of positive acquirer cashholdings effect. Based on these results, we question the validity of a vested view that cash-rich acquirers make value-destroying acquisitions. Our study suggests that investors perception about acquirer s cash holdings has evolved over time. As Fresard (2010) noted, not long ago, cash holdings were considered dangerous to shareholders. However, recent developments in finance research and turmoil in financial markets have highlighted the possible benefits of cash holdings. Our results confirm that the balance between the costs and benefits of acquirer cash holdings depends on the strength of financial constraints and shareholder rights. Our study builds on the precautionary motive of cash holdings, which is formalized in a few theoretical studies (Almeida et al., 2004; Kim, Mauer, and Sherman, 1998; Han and Qiu, 2007) and supported by a strand of empirical literature (Kamien and Schwartz, 1978; Opler et al., 1999; Almeida et al., 2004; Ozkan and Ozkan, 2004; Khurana, Martin, and Pereira, 2006; Opler et al., 1999; Bates, Kahle, and Stulz, 2009; Gryglewicz, 2011; Mikkelson and Partch, 2003; Acharya, Almeida and Campello, 2007; Franzoni, 2009; Duchin, 2010). However, previous research largely focuses on the determinants of cash holdings. Much less is understood about whether and how cash held under the precautionary motive enhance firm efficiency in major corporate investments. We fill in this gap by demonstrating that cash held in the presence of financial constraints and/or strong shareholder rights are associated with greater merger efficiency. The remainder of this paper proceeds as follows. Section 1 reviews the relevant literature and provides a context to develop our hypotheses. Section 2 specifies the hypotheses; Section 3 describes the sample and data; and Section 4 reports the empirical results. Section 5 concludes. 1. Literature review 6 Data needed to calculate the E-index have been available from RiskMetrics since

10 1.1. The performance of cash-rich acquirers Jensen (1986) postulates that firms holding excessive cash flows tend to make valuedestroying acquisitions. Consistent with Jensen s (1986) postulate, several studies find that acquirer cash flows or cash holdings are negatively related to merger performance. Lang et al. (1991) find that acquirers that have low Tobin s Q ratios but high free cash flows yield lower announcement returns. Schlingemann s (2004) reports, in his study of all-cash deals, that free cash flow negatively affects bidder announcement returns. Harford (1999) finds that, on average, greater excess cash holdings relates to worse acquirer performance (excess cash holdings can be viewed as free cash flows accumulated over time). Extending Harford s (1999) analysis, Oler (2008) observes that cash-rich acquirers produce worse long-term performance, measuring performance using both stock market returns and accounting data. Harford, Mansi, and Maxwell (2008) find that companies with weaker corporate governance deploy cash holdings to capital expenditures and acquisitions more quickly. As a result, weakly controlled managers hold less cash. Different from what we do, they focus on cash holdings decisions rather than investment performance. A later study by Harford, Humphery-Jenner, and Powell (2012) study the factors contributing to the value-destroying acquisitions made by entrenched managers. They demonstrate that entrenched managers endeavor to avoid lose of control in transactions, overpay the target and pursue low synergy targets in the first instance. Absent in their study is the role of cash regarding merger efficiency as well as the role of financial constraints in relation to the motive behind cash holdings. What s more, there are a few studies providing mixed evidence on how cash holdings affect investment performance. Morck, Shleifer, and Vishney (1990) argue that acquisitions can be driven by managerial motives and, thus, value-destroying; Richardson (2006) maintains that firms with high levels of free cash flow tend to invest above the optimal levels. In contrast, Mikkelson and Partch (2003) argue that firms that persistently hold large cash reserves neither perform poorly nor exhibit evidence of agency conflicts between managers and shareholders. The extant studies, however, are silent on how financial constraints and shareholder rights affect cash-rich acquirers investment efficiency. 8

11 1.2. Shareholder rights In their seminal study, Gompers, Ishii, and Metrick (2003) examine an important dimension of corporate governance shareholder rights. They aggregate 24 governance provisions into a G-index as a proxy for the strength of shareholder rights. They find that stronger shareholder rights relate to higher abnormal share price performance and greater firm value. In a later study, Bebchuk, Cohen, and Ferrell (2009) demonstrate that 6 of these 24 shareholder-rights provisions are most essential in determining firm value. They summarize these 6 provisions using an entrenchment index (E-index) to proxy for shareholder rights. The 18 provisions not included in their E-index are less relevant for firm value. A considerable literature examines how shareholder rights are related to abnormal stock returns. The results are mixed however. Following the original studies of Gompers, Ishii, and Metrick (2003) and Bebchuk, Cohen, and Ferrell (2009), researchers have shown that the relation between shareholder rights and abnormal stock returns is only present for those firms with significant pension fund holdings (Cremers and Nair, 2005), those in non-competitive industries (Giroud and Mueller, 2011), or firms in the 1990s (Bebchuk, Cohen, and Wang, 2013). Johnson, Moorman, and Sorescu (2009) argue that the relation between shareholder rights and abnormal stock returns disappears once industry clustering is considered. However, Lewellen and Metrick (2010) find the opposite. Despite these mixed observations, Bebchuk, Cohen, and Wang (2013) and Cremers and Ferrell (2014) suggest that restrictions on shareholder rights have a robust and persistent negative impact on firm value and operating performance. Several other related studies demonstrate that weaker shareholder rights are associated with lower announcement stock returns to acquirers in acquisitions (Masulis, Wang, and Xie, 2007), higher cost of equity (Chen, Chen, and Wei, 2011), and lower value of cash holdings (Dittmar and Mahrt-Smith, 2006; Pinkowitz, Stulz, and Williamson, 2006) Financial constraints, the value of cash and the precautionary motive of cash holdings 9

12 The value of cash has attracted much academic attention. On the one hand, excessive cash flows or holdings concern shareholders, as is postulated by Jensen (1986) and Stulz (1990). On the other hand, the precautionary motive (Almeida et al., 2004; Froot, Scharfstein, and Stein, 1993; Keynes, 1936) maintains that financially constrained firms benefit from holding more cash than they currently need if future opportunities are more profitable. These two theories are based on contrasting premises of principal-agent relations. Managers are self-interested under the agency theory, while they maximize shareholder value under the precautionary motive. Several studies document that the relation between cash and firm value varies according to the robustness of company corporate governance policies. Dittmar and Mahrt-Smith (2006) estimate that the value of $1.00 in cash is between $1.27 and $1.62 for well-governed firms but only between $0.42 and $0.88 for poorly governed firms. Using international data, Pinkowitz, Stulz, and Williamson (2006) observe that the value of cash is higher in countries with better investor protection. Both studies report evidence consistent with the view that firms waste cash when investor rights are weak but they hold cash for shareholders benefits when shareholder rights are strong. Theories of precautionary motive provide the theoretical foundation of the current paper. Keynes (1936) originally posited that a major benefit of cash holdings is that they enable a firm to undertake valuable investment opportunities whenever they arise, enhancing firm value ex ante. He further notes that the benefit of cash reserves is a function of the extent to which a company is financially constrained. An unconstrained company can access external financing any time and therefore needs no cash holdings. Consequently, cash holdings do not affect firm value in the absence of financial constraints. A subsequent body of literature demonstrates that financial constraints emerge under common market imperfections, e.g., adverse selection in equity markets (Myers and Majluf, 1984) and the agency cost of debt (Myers, 1977; Jensen and Meckling, 1976). Almeida et al. (2004) formally analyze the precautionary motive of cash holdings. In their model, a financially constrained firm chooses between a current and a future project. If the 10

13 manager believes that the future project is more valuable than the current one, she discards the current project and saves cash from current cash flows generated by the assets in place, so that she can invest in the future project when this opportunity arises. Optimal cash savings occur when the expected marginal return to the future project equals the expected marginal return to the current project. Importantly, keeping the concavity of the production function constant, the more valuable the future project is compared to the current one, the stronger the incentive to save part of the current cash flow (p1785 Almeida et al., 2004). Almeida et al. (2004) assume that companies can fully hedge the risk of cash flow generated from the assets in place. As a result, a company is only concerned with the expected value of cash flows and not cash flow volatility. Han and Qiu (2007) extend Almeida et al. s (2004) model by assuming that firms can only partially hedge their cash flow risk, demonstrating that when the marginal return to investing in the future project is convex for a given amount of cash saved from current cash flows, the marginal return to the future project increases with cash flow volatility. The increased marginal return to the future project induces managers to save more cash from current cash flows to equalize the marginal returns to both current and future projects (proposition 1, Han and Qiu, 2007). When the concavity of the production function is constant, a greater marginal return implies a higher value future project. In Appendix C, we elaborate the mechanism that generates this positive relation between optimal cash savings and future project value. Our focus here is not on the cash flow sensitivity of cash. Rather, we emphasize the positive relation between optimal cash holdings and the value of a future project relative to a current project, as modelled by Almeida et al. (2004). An earlier study by Kim, Mauer, and Sherman (1998) also models optimal company cash savings in relation to future investments. However, the trade-off in their model is not between current and future projects but between investments and cash savings in the same period. In another theoretical study, Froot, Scharfstein, and Stein (1993) posit that higher cash reserves enhance firm value by shielding investment capability from the negative impact of volatile cash 11

14 flows. In a more recent study, Riddick and Whited (2009) demonstrate that firms hold more cash when external financing is more costly or when firm cash flows are riskier. A strand of literature provides empirical evidence consistent with the precautionary motive. Extant studies have demonstrated that high-growth companies hold more cash in both the U.K. and U.S. (Kamien and Schwartz, 1978; Opler, Pinkowitz, Stulz, and Williamson, 1999; Almeida et al., 2004; Ozkan and Ozkan, 2004; and Khurana, Martin, and Pereira, 2006) and that higher cash flow volatility is associated with greater cash holdings (Han and Qiu, 2007; Opler et al., 1999; Bates et al., 2009; and Gryglewicz, 2011). Acharya et al. (2007) demonstrate both theoretically and empirically that firms prefer to hold more cash rather than retire debt when they expect a financing gap between cash flows and investment opportunities (i.e., cash flows and investment opportunities are not synchronized). Duchin (2010) finds that diversified companies hold less cash when investment opportunities at the divisional level are less correlated and when cash flows at some divisions are highly correlated with the investment opportunities available to other divisions (a smaller financing gap). He argues that this pattern occurs because diversified companies can transfer cash across divisions to finance investments. However, to our knowledge, previous literature largely focuses on the determinants of cash holdings under the precautionary motive. Much less is known about how companies benefit from cash held under the precautionary motive. In this paper, we fill this gap by demonstrating that cash-rich acquirers with financial constraints or strong shareholder rights benefit from making acquisitions. 2. Hypotheses The precautionary motive predicts a positive relation between acquirers cash holdings and their performance. Because the precautionary motive is most pronounced when a firm has severe financial constraints and/or strong shareholder rights, this positive relation should be most pronounced among more financially constrained acquirers and/or those with strong shareholder rights. As is already mentioned in the introduction, announcement returns are driven by updated 12

15 acquisition probability. We therefore expect the positive cash holdings effect to be most obvious when a deal is not predicted by the market. Our hypotheses are below: Hypothesis 1 (H1): A cash-rich acquirer has better announcement returns than a cash-poor acquirer. Hypothesis 1a (H1a): The positive cash holdings effect on acquirer announcement returns is more pronounced for unpredicted acquisitions. Hypothesis 1b (H1b): When shareholder rights are strong, a cash-rich acquirer experiences higher announcement returns than a cash-poor acquirer. Hypothesis 2c (H1c): When financial constraints are more severe, a cash-rich acquirer experiences higher announcement returns than a cash-poor acquirer. Deal synergies should manifest themselves through long-term operating performance after an acquisition; therefore, we formulate the following hypotheses: Hypothesis 2 (H2): A cash-rich acquirer has better post-acquisition operating performance than a cash-poor acquirer. Hypothesis 2a (H2a): When shareholder rights are strong, a cash-rich acquirer experiences better post-acquisition operating performance than a cash-poor acquirer. Hypothesis 2b (H2b): When financial constraints are severe, a cash-rich acquirer experiences better post-acquisition operating performance than a cash-poor acquirer. We distinguish between predicted and unpredicted acquirers in the test of H1a; a full discussion is presented in Appendix D. We elaborate the mechanism that drives the positive relation between acquirer cash holdings and the value of an acquisition in Appendix C, i.e., why E(V H ) > E(V L ), as is mentioned in the introduction. 13

16 3. Sample and Data Our initial acquisition sample originates from the Security Data Corporation (SDC) mergers and acquisitions (M&A) database. For the U.K. and the U.S., the sample period is from 1984 to We then impose several selection criteria to the initial samples. First, following Harford (1999), we include only the major types of acquisitions, namely, mergers, acquisitions of majority interests, acquisitions of remaining interests, and acquisitions of partial interests. 7 Second, all acquisitions were completed, which allows us to analyze post-acquisition operating performance. Third, following Harford (1999), both the acquirer and the target must be publicly listed firms. One benefit of focusing on public targets is that we avoid confounding issues, such as concerns about loss of control to potential block shareholders and target demand for liquidity (Chang, 1998; Fuller, Netter, and Stegemoller, 2002). It also allows us to compare our results to those of previous studies. A practical reason to exclude private targets is that target data are required to calculate the operating performance of the merging firms prior to the acquisition. Fourth, means of payment (i.e., percentages of stock, cash, or mixed payments) must be available from the SDC. To mitigate problems associated with recording error, we require the sum of the percentages of stock, cash, and mixed payments to be between 95% and 105%. Fifth, transaction value must be available and no less than 10 million. This criterion eliminates transactions that have little price impact. Sixth, deal announcement and completion dates must be available from the SDC. Seventh, we exclude financial acquirers (SIC ) whose cash holdings are of a different nature than those of industrial firms and utility acquirers (SIC ), which are intensely regulated. Eighth, we require data to be available to calculate performance measures (from DataStream for the U.K. and Compustat for the U.S.). To measure acquirer announcementperiod performance, we calculate the cumulative abnormal returns (CAR) from two days before 7 These transactions are defined by the SDC and are commonly used in M&A studies. In a merger, all shares outstanding of the target are acquired by the acquirer. In an acquisition of majority interests, the acquirer holds less than 50% of the target before the transaction and more than 50% after the transaction. In an acquisition of minority interests, the acquirer holds less than 50% of the target before the transaction and less than 50% after the transaction. In an acquisition of remaining interests, the acquirer holds more than 50% of the target before the transaction and the entire target after the transaction. 14

17 to two days after the announcement, i.e., CAR ( 2, +2). Abnormal returns are estimated using the market model. If the announcement day is a public holiday, we use the subsequent trading day as day 0. The estimation period is a 250-day window ending 15 trading days before the announcement day (we require at least 30 non-missing daily stock returns within the estimation window). A 5-day test period is chosen in case the announcement date listed in the SDC is inaccurate. To measure operating performance, we follow Healy, Palepu, and Ruback (1992); Harford (1999); and Powell and Stark (2005). In particular, we measure operating performance by first deducting the change in working capital from the operating cash flow and then scaling by total assets. We adjust an acquirer s operating performance using the median performance of other firms in the same industry, size decile, and operating-performance decile. The final measure, Post-acquisition operating performance, is the combined firm s adjusted operating performance averaged over the three years following deal completion. Pre-acquisition operating performance is the value-weighted (using the market value of assets) combination of the acquirer s and target s adjusted operating performances, averaged over the three years prior to deal announcement. Ninth, we require that data are available (from DataStream and Thomson One Banker for the U.K. and CRSP and Compustat for the U.S.) to calculate the excess cash reserve ratio as defined in Appendix B and the predicted and unpredicted acquirers as defined in Appendix D. Cash holdings can be accumulated from either internal or external cash flows. For example, Kim and Weisbach (2006), Hertzel and Li (2010) and McLean (2011) posit that firms issue shares to hoard cash when the cost of external equity is low. The focus of this paper, however, is not on how excess cash holdings are accumulated. The model presented by Almeida et al. (2004) can incorporate external cash flows with minimal modification. Tenth, we require all control variables in our regressions to be calculated from the data provided by DataStream, Thomson One Banker, CRSP, or Compustat. The control variables are as follows: probability of being an acquirer (defined in Appendix D); acquirer total assets; acquirer market-to-book ratio (defined as the sum of the market value of equity and the book value of long-term liabilities divided by the sum of book value of equity and book value of long-term liabilities); acquirer leverage (defined as the book value of debt over total assets); acquirer asset tangibility (defined 15

18 as the ratio of tangible assets to total assets); acquirer return on assets (ROA) (defined as operating income over total assets); relative deal value (defined as the deal value divided by the bidder s market value of equity); acquirer average sales growth over the two years before deal announcement; and cash payment (%) (the percentage of consideration paid in cash). All acquirer characteristics are measured at the fiscal year end prior to deal announcement, unless otherwise stated. For approximately 30% of our final U.K. sample, DataStream codes are available, but accounting information is missing from WorldScope. We manually collect accounting data for these acquirers from the annual reports provided by Thomson One Banker. All variables are measured in 1994 values. The final sample includes 564 (2423) acquisitions with the full range of data for our main regression analysis for the U.K. (the U.S.). The U.K. sample is substantially smaller than the U.S. sample; however, this sample size is comparable to other U.K. studies, e.g., Gregory and O Donohoe (2014) report a sample of 288 public targets during the period. Our regression specifications are robust to outliers and heteroskedasticity. We also winsorize all continuous variables at the 1 st and 99 th percentiles, except for the CAR. Panel A of Table 1 reports the summary statistics of the U.S. sample. The CAR ( 2, +2) has a mean of 0.3% and a median of 0.6%, neither of which is statistically significant (test statistics not tabulated). The mean excess cash reserve ratio is 0.2% (median 0.1%), suggesting that U.S. acquirers on average are close to their target level of cash holdings. An average acquirer has an adjusted operating performance of 5.6% prior to deal announcement and 8.5% after deal completion, which suggests that acquisitions are value enhancing in the U.S. The average Whited-Wu index is 1.33 and the median is 0.24, which suggests that in the U.S., some acquirers are extremely financially constrained. Of the acquirers, 1,251 of 2,423 firms have never obtained a bond rating. The average E-index value is and the median is 3, suggesting that on average, the shareholders of our sample acquirers are not weak; however, substantial differences in shareholder power exist (i.e., the standard deviation is 1.44). Of the acquirers, 1,762 of 2,423 firms have separated leadership structures, which suggest that for a majority of 16

19 our sample, acquirer managerial power is contained to some extent. There is no statistically significant unconditional difference between high- and low-cash groups in terms of the CAR ( 2, +2). In terms of operating performance, the high-cash group outperforms the low-cash group before acquisitions with marginal statistical significance (z-statistic = 1.879) and significantly outperform after acquisitions (z-statistic = 2.011). High-cash acquirers are less financially constrained. In particular, high-cash acquirers have an average Whited-Wu index of 0.131, and 601 of 1,212 high-cash acquirers have never received a bond rating, while the low-cash group has an average Whited-Wu index of 0.306, and 650 of 1,211 low-cash acquirers have never obtained a bond rating. The high- and low-cash groups have similar E-index values, but the highcash group has less acquirers with separated leadership. Panel B of Table 1 reports the summary statistics of the U.K. sample. The acquirer CAR( 2, 2) has a mean of 0.2% and a median of 0.1%, and neither is significantly different from zero (test statistics not tabulated). The mean excess cash reserve ratio is 3.6% (median 0.8%), which indicates that, on average, U.K. acquirers have cash reserve ratios below their target levels. An average acquirer has an adjusted operating performance of 3.7% prior to the deal announcement and 6.6% after deal completion, suggesting that acquisitions in the U.K. enhance value. The average Whited-Wu index is 0.84 (median 0.59), and 257 of the 564 acquirers have never obtained a bond rating. Institutional holdings are substantial, constituting 41.15% of total shares outstanding (median 11.09%), and 144 acquirers have total institutional holdings above 3%. In the right-hand section of Panel B, we report the median values of acquirers with high (above the median) and low excess cash holdings. Acquirers with high cash holdings have CAR ( 2, +2) significantly higher than that of acquirers with low cash holdings (z-statistic = 2.528). In terms of operating performance, the high-cash group outperforms the low-cash group both before and after acquisitions, with statistical significance at the 5% (z-statistic = 2.064) and 10% level respectively (z-statistic = 1.751). The high-cash group has greater growth than the low-cash group, as is indicated by the market-to-book ratio of assets (1.529 vs ). High-cash acquirers are less financially constrained by the Whited-Wu index. They have a median Whited- 17

20 Wu index of 0.499, while low-cash acquirers have a median of In terms of bond rating, high- and low-cash acquirers are similar: 130 of the 282 high-cash acquirers and 127 of the 282 low-cash acquirers have never obtained a bond rating. Institutional holdings are greater for the high-cash group (median %) than for the low-cash group (median 9.801%) (z-statistic = 1.741). There are 76 of the 282 high-cash acquirers having institutional holdings greater than 3%. There is a smaller number of low-cash acquirers having total institutional holdings greater than 3% is lower (68 of 282). [TABLE 1] 4. Empirical results In this section, we present the U.S. results first, and then the U.K. evidence The positive cash holdings effect on bidder announcement returns in the U.S. We use the following baseline model to test H1: CAR Excash Controls YDUM INDDUM, (1) i 1 i i i i i where i indexes the acquisitions; CAR is the acquirer s cumulative abnormal returns from 2 trading days before to 2 trading days after the announcement day, i.e., CAR ( 2, +2); Excash is the acquirer s excess cash reserve ratio; and Controls is a vector of control variables suggested by previous research, which includes the probability of being an acquirer, bidder size measured by log (1 + total assets), asset tangibility, returns on assets, log (1 + average sales growth), log (1 + market-to-book ratio), leverage, relative deal value, cash payment (%), tender offer dummy, friendly deal dummy, and diversifying deal dummy. YDUM and INDDUM are the year and industry effects, respectively. We control for the probability of being an acquirer because otherwise, two acquisitions of the same value may have different announcement returns to the 18

21 acquirers, depending on the extent to which the deals are anticipated by the market. The probability of being an acquirer is estimated using Equation (D.1) in Appendix D. Equation (1) is a naive specification in that it does not take into consideration how the degree of market anticipation alters the acquirer s cash-holdings effect on performance. To test H1a, we use the following specification, which accounts for the degree of market anticipation: CAR Excash Predicted-acquirer Dummy i 2 i i Excash Unpredicted-acquirer Dummy 3 i Unpredicted- acquirer Dummy Controls YDUM INDDUM i i i i i i, (2) where the Unpredicted-acquirer Dummy is 1 for an unpredicted acquirer and 0 otherwise; the Predicted-acquirer Dummy is defined in the opposite manner (see Appendix D for a detailed explanation of predicted and unpredicted acquirers). There is a concern that this classification scheme tends to classify low-cash acquirers as unpredicted acquirers because cash holdings positively predict being an acquirer. However, we compare the mean and median excess cash holdings between predicted and unpredicted acquirers (not tabulated) and find no significant differences. Therefore unpredicted acquirers are not equivalent to acquirers with low cash holdings. We commence our analysis by examining cash-rich acquirers performance in the U.S. The U.S. institution empowers management to a great extent. However, shareholder rights at the firm level vary substantially. We use the E-index of Bebchuk, Cohen, and Ferrell (2009) and combined/separated leadership (Brickley, Coles, and Jarrell, 1997; Rechner and Dalton, 1991; Baliga, Moyer, and Rao, 1996) to distinguish between firms with strong and weak shareholder rights. As is explained in the introduction, the E-index summarizes the most value-relevant governance provisions identified by Gompers, Ishii, and Metrick (2003). A higher E-index indicates greater shareholder rights because shareholders face fewer restrictions to their voting power and management is less insulated from internal or external control (Bebchuk, Cohen, and Ferrell, 2009). Under separated leadership where the chairperson and CEO are different persons, 19

22 the chairperson provides an effective counterbalance to dictatorial CEO power inherent with the combined leadership structure (the CEO and the chairperson are the same person). Overall, our results reveal that cash-rich acquirers have better announcement returns when they are financially constrained and/or their shareholders have strong rights. Cash-rich acquirers underperform only when they are less financially constrained and shareholders have weak rights. Table 2 and 3 provides more details. As is already explained, we use a high Whited-Wu index dummy and a No bond ratings dummy to indicate financially constrained acquirers and use the E- index and the separated/combined leadership to measure the strength of shareholder rights. In Table 2, Model 1 tests H1 based on the naive specification of equation (1). We estimate the model on the full sample, regardless of financial constraints or shareholder rights. The variable log (1 + excess cash reserve ratio) has a significant (at the 1% level) negative coefficient of 0.043, which appears to be consistent with the agency theory of free cash flow. Model 2 tests H1a based on equation (2), using the full sample regardless of financial constraints or shareholder rights, but distinguishing between predicted and unpredicted acquirers. The cash holdings effect for unpredicted acquirers is significant and positive, consistent with H1a. Specifically, the interaction between unpredicted acquirer dummy and log (1 + excess cash reserve ratio) is and significant (at 1%). A one-standard-deviation increase in the acquirer s excess cash reserve ratio is associated with a 1.2 percentage point increase in acquirer CAR ( 2, +2). This result persists when we add the high Whited-Wu index dummy to Model 2 (not tabulated). This result is different from the negative impact of acquirer cash holdings on merger performance observed for by Harford (1999). That cash-rich acquirers perform better during our sample period of concurs with the increased relevance of precautionary motive (Bates, Kahle, and Stulz, 2009) and the increases in market participants attention to governance and shareholder rights (Bebchuk, Cohen, and Wang, 2013; Cremers and Ferrel, 2014; Gillian and Starks, 2000), which can be reasons for this revised cash holdings effect. To ensure that our results are not due to empirical design, we estimate Model 2 for the 20