RISK-RETURN PERFORMANCE OF RELATED VERSUS UNRELATED ACQUISITIONS

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1 RISK-RETURN PERFORMANCE OF RELATED VERSUS UNRELATED ACQUISITIONS Alok Srivastava, Georgia State University, USA Sangsoo Kim, Hyosung University, Korea ABSTRACT This study isolated the effects of acquisitions on the long term risk-return performance of acquiring firms involved in related and unrelated diversifying acquisitions. Confounding effects of multiple acquisitions were controlled by studying only those firms that were involved in a single major acquisition over a ten year period surrounding the acquisition date. Acquisitions did not improve the profitability performance of acquiring firms. Although not statistically significant, firms involved in related acquisitions experienced profitability setbacks. On the risk dimensions, the overall risk of acquiring firms involved in related acquisitions increased in the post-acquisition period. Risk pooling advantages were associated with unrelated mergers as demonstrated by their abiliity to maintain their risk profile. Risk-return relationships were found to be negative for firms involved in both kinds of acquisitions. Firms that succeeded in reducing total or financial risk enjoyed superior returns. Capital structure-return relationships were also significant and negative across both categories of acquisitions implying profitability setbacks for firms that utilize excessive leverage to finance acquisitions. INTRODUCTION Acquisitions continue to play a pivotal role in the implementation of corporate strategy. External growth through acquisitions has become an attractive option for firms pursuing different diversification strategies. Trends in the acquisition behavior of large firms indicate that conglomerate acquisitions are still very popular, while synergy oriented vertical and horizontal mergers are now less popular (Michel and Shaked, 1985). Are these patterns of acquisitions indicative of a superior acquisition strategy? Do acquisitions and mergers succeed in creating value for the shareholders? In the absence of a concrete theory of diversification, the debate on relative superiority of a certain acquisition strategy over others remains unresolved. Increasing value of the acquiring firm has been promoted as the most important motive for acquisitions and mergers. Due to the absence of a good measure of value, a number of studies have evaluated acquisition success by examining the risk-return characteristics of firms employing various acquisition strategies (Silhan and Thomas, 1986; Lubatkin, 1983, 1987; Dundas and Richardson, 1982; Beattie, 1980; Salter and Weinhold, 1978; among others). Within the risk-return framework it has been argued that the motivational framework for all types of acquisitions is the same (Steiner, 1975). This line of thought would lead us to believe that since alternative types of economic activity are a part of the same choice set, one type of acquisition strategy is not likely to have an advantage over other strategies. Contarary to the notions of portfolio theory, several studies have found superior performance associated with strategies involving related businesses implying value creation by synergy oriented acquisitions (Rumelt, 1974; Mason and Goudzwaard, 1976; Leontiades, 1980; Christensen and Montgomery, 1981; Bettis and Hall, 1982; and McDougall and Round, 1984; Chaterjee, 1986; Lubatkin and O'Neil 1987). Lubatkin (1983), in his extensive review of the acquisition literature, developed a framework to identify potential synergies associated with each type of acquisition. Technical economies were possible in related acquisitions, while unrelated acquisitions were associated with financial and diversification synergies. Drucker (1981) outlined five rules for successful acquisitions which strongly advocate related acquisitions. Using a small sample of 26 firms, Power (1982) found that all related acquisitions included in the sample ranked among the top one-third of the perceived effectiveness scale implying that synergy-oriented mergers are perceived to have a higher potential for success. On the other extreme, some studies have found unrelated acquisition strategy to be a superior one in terms of improving firm performance (Elger and Clark, 1980; Kitching, 1967). Unrelated acquisitions may succeed in creating significant economic value through improved cash management, efficient allocation of investment capital, and/or a reduced cost of debt (Salter and Weinhold, 1978, Leontiades, 1982). One possible explanation for superior wealth effects associated with unrelated acquisitions is that when the income stream becomes more stable after the merger, the market value of debt of the combined firms increases due to co-insurance effects.

2 Based on the work of Salter and Weinhold (1978), Dundas and Richardson (1982), and Beattie (1980), Silhan and Thomas (1986) proposed that conglomeration provides opportunities to increase market value when either risk or return can be improved while holding the other constant. Marshall et al. (1982) showed that conglomerate mergers are aimed at diversifying into industries that reduce the acquiring firm's exposure to systematic risk. In a more general study, Song (1983) found that mergers decrease volatality of earnings and sales. Other arguments supporting the risk reduction rationale include those of making debt safer (Lewellen, 1971), and reduction of bankruptcy risk (Higgins and Schall, 1975). Several studies have found that compared to non-conglomerate firms, conglomerates reduce risk (Melicher and Rush, 1974; Holzmann et al. 1975; Beattie, 1980; Beedles, et al. (1982); among others). Risk-reduction is such a popular rationale for diversification that risk-return tradeoffs have to be examined in assessing performance (Bowman, 1980). Inconsistencies and contradictions in the acquisitions and diversification literature may be due to differences in methodological approaches employed by various researchers. One important shortcoming of earlier research may have been the failure to incorporate a host of environmental, industry, and firm-specific factors in assessing post-acquisition performance. Differences in the time frame of various studies may have also contributed to the present confusion regarding performance implications of acquisitions. A more apparent reason is the differences in the employment of performance measures. Another short coming of earlier research is the lack of control for the effects of multiple acquisitions (Lubatkin, 1983). Firms usually embark on acquisition programs that result in the acquisition of several firms over a short period of time. This makes it difficult to study effects of specific acquisitions on long term performance of acquiring firms. This study was designed to address some of these concerns in order to gain a better understanding of performance implications of acquisitions. Confounding effects of multiple acquisitions were controlled by studying only those firms that were involved in a single large acquisition during a ten-year period surrounding the acquisition date. Since divestitures can change profiles of firms only firms that did not make significant divestitures were studied. Data over a long time frame ( ) were used to capture different states of the general economy in order to make results more generalizable. Instead on focusing only on post acquisition performance, this study examined long term changes in risk-return performance to capture performance effects of acquisitions and to control for effects of contextual variables. Since each firm operates in a unique environment described by its contextual variables, one would expect different firms to have different levels of performance due to differences in contexts. These effects would be constant over different time periods. If the acquisition was the only change in a firm's environmental context, its effect could be captured by measuring the change in long term performance. Moreover, this difference in post- and pre-acquisition performance would automatically control differences in contexts of acquiring firms since effects of context variables are assumed to be constant over different time periods. By incorporating such methodological issues, and by addressing limitations of earlier studies, it is hoped that results of this study will provide us with a better understanding of performance implications of corporate acquisitions. The following hypotheses (stated in null form) were tested to accomplish objectives of this study. H1 : Acquisitions do not improve the long term risk-return performance of acquiring firms in general, and of firms pursuing either related or unrelated acquisition strategies. H2 : Risk and Return have no significant relationship for acquiring firms in general, and for firms pursuing related and unrelated acquisition strategies. METHODOLOGY THE SAMPLE: The Federal Trade Commission's Statistical Report on Acquisitions & Mergers was used to obtain a list of large acquisitions that were completed. A large acquisition was defined as one that resulted in a ten percent increase in the acquiring firm's assets. 2

3 This list was further reduced by eliminating firms that were involved in more than one large acquisition. A firm was also dropped if all of its other acquisitions resulted in more than two percent increase in assets. To control effects of divestitures, any firm that divested over two percent of its assets was dropped. The final constraint was availability of data on the COMPUSTAT tapes. FTC's classification of acquisitions was used to identify the type of acquisition strategy that was implemented. Since the primary focus of this study was to compare performance of firms involved in unrelated acquisitions with that of firms involved in related acquisitions, only two samples were used in all analyses. "Related" acquisitions was the first sample which consisted of all horizontal, product extension, and market extension acquisitions. "Unrelated" acquisitions represented the other sample. There were 65 firms in the related sample and 33 in the unrelated sample. VARIABLES AND MEASURES: The performance variables were accounting-based measures that covered profitability and risk dimensions. The profitability measures were five year averages of Return on Assets (ROA) and Return on Equity (ROE). Risk (SROE) was measured by the standard deviation of five year return on equity values (Bowman, 1980, 1982). Capital structure, a measure of financial risk, was measured by five year average Debt to Equity ratio. All variables, except the risk variables were five year averages. Five year averages were computed for both post- and pre-acquisition period. The change in long term performance was computed as the difference in the five year post- and pre-acquisition averages (D_ROA, D_ROE and D_Risk). DATA ANALYSES AND RESULTS To address the question whether acquisitions improve performance, irrespective of the type of acquisition, pairwise `t' tests were performed on each of the differences in the post and pre-acquisition performance variables. The results are tabulated in Table 1. This methodology was employed to determine whether the acquisition had any effect on the long term performance of acquiring firms. On the profitability dimension, the change in long-term profitability measures DROA and DROE of acquiring firms were not significant. Although the differences were not significant, it is interesting to note that the sign associated with the DROA and DROE were negative, implying decreasing profitability of firms involved in acquisitions. Consistent with Fowler and Schmidt's (1989) finding, it can be inferred that on the overall, acquisitions have an adverse effect on the profitability of acquiring firms. The next step was to perform the same analyses for the related and unrelated samples. The purpose of this analysis was to determine if the results for "all firms" applied to all kinds of acquisitions, or if a certain acquisition strategy was superior than the other in terms of improving long term profitability. Results were consistent with those for the whole sample. Both related and unrelated mergers did not improve the long term profitability of acquiring firms, in terms of ROA and ROE. It is surprising to note that acquiring firms exposure to risk actually increased after the acquisition. Given the economic conditions characterized by the time period of this study, it can be inferred that acquisitions in general may actually increase the firm's exposure to risk. The difference in debt to equity averages (D DE), or change in financial risk was not singificant, although the sign associated with the difference was positive implying a relatively greater use of debt by acquiring firms in the post-acquisition period. Sample Variable Mean t D_ROA All Firms D_ROE D_Risk ** D_DE

4 D_ROA Related D_ROE D_Risk ** D_DE D_ROA Unrelated D_ROE D_Risk D_DE ** p<.01 Table 1. Results of Pairwise "t" Tests Results on the risk dimension for related versus unrelated acquisitions are interesting. Firms that were involved in unrelated acquisitions did not show a significant change in their exposure to risk. On the other hand, firms involved in related mergers experienced a greater degree of variability in their earnings in the post-acquisition period. In conditions of economic uncertainty, inflation, and low stock valuation (Salter and Weinhold, 1982) increasing a firms dependence on its principal business may increase its exposure to economic fluctuations, as reflected in increased risk. Conglomerate mergers, on the other hand, may offer risk pooling advantages by diversifying into businesses that are not subject to similar economic conditions. This finding supports the notion that firms involved in conglomerate mergers peruse defensive strategies to maintain economic viability. Through better resource allocation and by utilizing benefits associated with co-insurance of debt, conglomerates may be able to maintain a more steady flow of earnings. On the risk dimensions, the related sample had much higher increases compared to those of the unrelated sample. Conglomerate acquisitions may create value in terms of controling risk and ensuring a steady flow of returns by diversifying into industries that can result in a better control over variability of returns (Marshall et al., 1982; Bowman, 1980), especially under conditions of economic instability. Hypothesis H2 was tested by computing correlation coeficients between the post-acquisition profitability (return) measures and the risk variable. The change in risk (D_RISK) was also correlated with the return variables. This was done to examine the effect of increasing a firms overall risk on its profitability. Correlation coefficients were first computed for all firms and then for each subsample. The results are tabulated in Table 2. Sample ROA ROE Risk All Firms D_Risk DE D_DE Risk Related D_Risk DE

5 D_DE Risk Unrelated D_Risk DE D_DE ** p<.01 * p<.05 Table2. Results of Correlation Analyses All correlation coefficients between risk and return were significant at p <.01. It is not surprising to note that there was a negative relationship between risk and return for both the related and the unrelated sample. Firms whose risk level increased after the acquisition, experienced reduced profitability. This finding was true for both the related and the conglomerate samples. The sign associated with the correlation coefficients was negative in every case, for each sample. It is revealing to note that the magnitude of the coefficients were also approximately the same for different samples. These results indicate that irrespective of the type of acquisition strategy a firm pursues, there is a negative risk-return relationship. If an acquisition increases risk, there is bound to be a declining effect on profitability, irrespective of the type of acquisition. Correlation coefficients were also computed using the change in financial risk (D DE) to study the impact of increasing capital structure on the profitability of acquiring firms. Results of these analyses are also shown in Table 2. Firms that employed a higher level of debt in their capital structure had lower profitability. This is evidenced by the negative correlations between DE with both ROA and ROE. All correlation coefficients involving DE were negative and significant at p <.01. The relationship between DE and profitability was the same for both the related and conglomerate samples. Just like the risk-return relationships, capital structure-return relationships were consistent, both in terms of magnitude and direction, across all categories of firms. These findings indicate that excessive debt financing has a negative impact on profitability. It should be observed that the magnitude of the coefficients of DE with ROE were smaller than those of DE with ROA. If debt increases, relative equity decreases which might have a smoothing effect on ROE. It is thus possible for agressive firms to control ROE through agressive financial strategies. Easy availability of debt capital has encouraged a greater number of firms to contemplate mergers and acquisitions. More and more acquisitions are being financed through debt, and the word "leveraged buyout" has become a common corporate phenomenon. To study the effect of change in capital structure, due to acquisitions, D DE was correlated with ROA and ROE (Table 3). D DE had a significant negative correlation coefficient with ROA for "all firms" and the "conglomerate" sample. The correlation coefficient between D DE and ROA for related firms was not significant, possibly due to low level of debt financing by firms in the related sample. Related firms that already had a low capital structure could increase debt, without experiencing great setbacks on profitability. While firms in the conglomerate sample, which already had greater debt in their capital structures, further increase in debt had a negative impact on ROA. CONCLUSIONS Consistent with the notions of portfolio theory, this study attributed superior performance to firms involved in unrelated acquisitions. As argued by Bowman (1982), firms can increase their value by reducing risk while holding returns constant. 5

6 Evidence for such increases in value were found for firms involved in unrelated acquisitions. Tradeoffs in risk and return were suggested by Bettis and Mahajan (1985), who found that firms that diversified into unrelated businesses usually sacrificed some returns for lower levels of risk. Our results indicate that unrelated acquisitions resulted in maintaining the risk-return profiles of acquiring firms. A number of researchers have studied sources of strategic relatedness among acquiring and acquired firms (Salter and Weinhold, 1979; Chaterjee, 1986; Lubatkin, 1987), proposing that firms involved in related acquisitions have a greater chance at value creation due to the potential for accomplishing operating synergies. Consistent with Kitching's (1967) results, this study found no evidence of value creation by firms involved in related acquisitions. On the contrary, firms involved in related acquisitions were associated with decreased profitability and increased risk. This evidence for negative synergy may be due to increased reliance on existing product-markets, or the failure of acquiring firms in accomplishing synergy. These results call for a thorough examination of the relationship between acquisition strategy and accomplishment of synergy. REFERENCES Beattie, D. L. "Conglomerate diversification and performance: a survey and time series analysis," Applied Economics, 1980 Bettis, R. A. and Hall, W. K. "Diversification Strategy, Accounting Determined Risk, and Accounting Determined Return," Academy of Management Journal, 25, 1982, pp Bowman, E. H. "A Risk/Return Paradox for Strategic Management," Sloan Management Review, Spring 1980, pp Bowman, E. H. "Risk seeking by troubled firms," Sloan Management Review, Fall 1982, pp Chatterjee, S. "Types of Synergy and Economic Value: The impact of Acquisitions on Merging and Rival Firms," Strategic Management Journal, 7, 1986, pp Christensen, H. K. and Montgomery, C. A. "Corporate Economic Performance: Diversification Strategy Versus Market Structure," Strategic Management Journal, 2, 1981, pp Drucker, P.F. "The Five Rules of Successful Acquisition." The Wall_Street Journal, Thursday 15 October, Dundas, K. N. M. and Richardson, P. R. "Implementing the unrelated product strategy," Strategic Management Journal, 3, 1982, pp Elgers, P.T. and Clark, J.T. "Merger Types and Shareholder Returns: Additional Evidence." Financial Management, 9, Fowler, K. L. and Schmidt, D. R. "Determinants of tender offer post acquisition financial performance." Strategic Management Journal, 10, 1989, pp Higgins, R. C. and Schall, L. D. "Corporate bankruptcy and conglomerate merger." Journal of Finance, 30, 1975, pp Holzmann, O. J., Copeland, R. M., and Hayya, J. "Income measures of conglomerate mergers." Quarterly Review of Economics and Business, 15(3), 1975, pp Kitching, J. "Why do Mergers miscarry?", Harvard Business Review, November-December 1967, pp

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