The Long-Term Operating Performance of European Mergers and Acquisitions: Private vs. Public

Transcription

1 The Long-Term Operating Performance of European Mergers and Acquisitions: Private vs. Public Master Thesis, Master Finance, Tilburg School of Economics and Management, Tilburg University, The Netherlands Nick de Leeuw BSc Student number: Graduation date: 20 December 2012 Supervisor: prof. dr. V. Ioannidou

2 Abstract In this study, I investigate whether European companies are able to improve their long-term operating performance by engaging in mergers and acquisitions. 1 Furthermore, I examine whether the performance development can be predicted by some classic deal characteristic and I introduce the legal form of the acquirer, private versus public, as possible explanatory variable. 2 This study contributes to the existing literature for three reasons. Firstly, although the literature on M&A stock performance is extensive, the number of studies on postacquisition operating performance is limited and the results are inconclusive. Secondly, the literature on operating performance following European mergers and acquisitions is even more limited. To my best knowledge only Mueller (1980), Gugler et al. (2003) and Martynova et al. (2006) focus on M&A activity by European firms, reporting contradictory results. Thirdly and most importantly, this research is, in my understanding, the first study to distinguish between the M&A performance of privately held acquirers and publicly traded acquirers, potentially directing a wide-range of future research. The results suggest that European companies are unable to use mergers and acquisition to improve their long-term performance. In contrast, depending on the measurement and adjusting methods employed, which possibly explains some of the contradictions in prior research, post-acquisition performance either decreases significantly or does not change significantly. Furthermore, I find that, although expected differently based on the literature on managerial incentives, the acquirer s legal form has no significant effect on post-acquisition operating performance. The analysis of some of the classic determinants of post-acquisition operating performance reveals that both method of payment and geographical scope have no significant explanatory power, whereas leverage and relative target size are positively related to post-acquisition operating performance, cash reserves are negatively related to post-acquisition performance and diversifying takeovers are more profitable than focused takeovers, at least for public acquirers. Nick de Leeuw BSc 1 In line with previous research, the terms merger, acquisition, takeover and M&A are used interchangeably throughout this paper. 2 Throughout this paper, I use the term classic determinants to refer to deal characteristics that have been widely studied as determinants of M&A performance. 1

3 Table of contents Abstract 1 Table of contents 2 1. Introduction 4 2. Literature review Accounting-based studies on M&A performance The post-acquisition operating performance of privately held companies Managerial incentives Classic determinants of post-acquisition performance Domestic versus cross-border Focused versus diversifying Relative target size Acquirer s cash reserves Acquirer s leverage Method of payment Data and methodology Sample selection Sample description Selection of peer companies Measures of operating performance Methodology Empirical results Does operating performance improve following M&A transactions? Private versus public Robustness check Classic determinants of post-acquisition performance Domestic versus cross-border Focused versus diversifying Relative target size Acquirer s cash reserves Acquirer s leverage Method of payment Multivariate analysis 26 2

4 5. Conclusion and recommendations 28 References 30 Tables 33 Table 1: Studies on post-acquisition operating performance 33 Table 2: Sample descriptives 34 Table 3: Size categorization 36 Table 4: Median changes in operating performance 37 Table 5: Median changes in operating performance by legal form 39 Table 6: Median changes in operating performance by ultimate owner 39 Table 7: Median changes in operating performance by geographical scope 40 Table 8: Median changes in operating performance by takeover strategy 41 Table 9: Median changes in operating performance by relative target size 42 Table 10: Median changes in operating performance by acquirer s cash reserves 43 Table 11: Median changes in operating performance by acquirer s leverage 44 Table 12: Median changes in operating performance by method of payment 44 Table 13: The change model versus the intercept model: robustness check 45 Table 14: Determinants of post-acquisition operating performance: multivariate analysis 46 3

5 1. Introduction wadays it is well-known that mergers and acquisitions come in waves. 3 Thus far five waves have been observed, those of the early 1900s, the 1920s, the 1960s, the 1980s and the 1990s. Most of these waves were dominated by M&A activity in the United States and the United Kingdom. However, during the fifth wave Europe s share in the worldwide M&A market, mainly due to the introduction of the Euro, the financial market boom, the globalization process, deregulation and privatization and technological innovation, increased substantially. Although the United Kingdom still accounted for a large fraction of the European M&A market, Continental Europe s M&A activity increased from transactions during the fourth wave ( ) to transactions during the fifth wave ( ). 4 Given the above, it is not surprising that early research on M&A activity focused mainly on the United States and the United Kingdom. However, empirical research did not keep up with the growing European M&A market. In this study, I investigate whether European companies are able to improve their long-term operating performance by engaging in mergers and acquisitions. Furthermore, I examine whether the performance development following takeovers can be predicted by classic deal characteristic, and I introduce the legal form of the acquirer, private versus public, as possible explanatory variable. This study contributes to the existing literature for three reasons. Firstly, although the literature on stock performance following M&A transactions is extensive, the number of studies on post-acquisition operating performance is limited and the results are inconclusive. Whereas some studies report significant declines in post-acquisition operating performance (e.g. Healey et al., 1992 and Rahman and Limmack, 2004), others document significant improvements in post-acquisition performance (e.g. Clark and Ofek, 1994 and Kruse et al., 3 Golbe and White (1993) were among the first to observe this cyclical pattern of M&A activity. 4 These numbers are derived from Martynova and Renneboog (2006). 4

6 2002) or no significant change (e.g. Martynova et al., 2006 and Ghosh, 2001). Secondly, the literature on the development of operating performance following European mergers and acquisitions is even more limited. To my best knowledge only Mueller (1980), Gugler et al. (2003) and Martynova et al. (2006) focus on M&A activity by European companies, reporting contradictory results. Thirdly and most importantly, this research is, in my understanding, the first to distinguish between the M&A performance of privately held acquirers and publicly traded acquirers, potentially directing a wide-range of future research. The current analysis is based on a sample of 416 European takeovers completed between 2003 and In an attempt to overcome some of the empirical limitations of prior research, I employ four different measures of operating performance and use both the change model and the intercept model to analyze these measures. I demonstrate that, in general, a company s operating performance, both unadjusted and adjusted for industry and size, decreases significantly following a takeover. However, when including changes in working capital in the industry and size adjusted performance measures, this decrease becomes insignificant, which indicates the importance of the measurement and adjusting methods employed and possibly explains some of the contradictions found in prior research. Furthermore, I find that the legal form of the acquirer has no significant effect on postacquisition operating performance. This suggests that either, in contrast to findings of Park (2007), managerial incentives are of less importance in M&A transaction than assumed to be or are minimized effectively, or privately held companies are not monitored as thorough as they are expected to be. The analysis of some of the classic determinants of post-acquisition operating performance reveals that both method of payment and geographical scope have no significant explanatory power, whereas leverage and relative target size are positively related to post-acquisition operating performance, cash reserves are negatively related to post- 5

7 acquisition performance and diversifying takeovers are more profitable than focused takeovers, at least for public acquirers. This paper is outlined as follows. Section 2 provides an overview of the most relevant empirical research on post-acquisition operating performance and its classic determinants, and explains the theory behind the analysis of M&A performance across acquirer s legal form. Section 3 describes the sample selection procedure and the characteristics of the final sample. Furthermore, it explains the selection of peer companies, the measurement of operating performance and the methodology applied. Section 4 provides the main results, while section 5 summarizes these results and concludes this paper. 2. Literature review During the past 20 to 25 years the profitability of mergers and acquisitions, especially those in the United States and the United Kingdom, has received much attention from academics and consultants. However, as Zollo and Singh (2004) stress, the existing research exhibits much heterogeneity in both the definition of performance and its measurement. After reviewing 97 papers published in top journals, Zollo and Meier (2008) conclude that, based on the measurement method applied, the existing research on the performance of M&As can be divided into three research streams. Finance and economic scholars most often rely on one of two objective measure categories namely, stock-market-based measures or accounting-based measures, while strategic management and organizational behavior scholars mostly rely on managers personal assessments, a subjective measure. Researchers have argued both in favor of and against these different measure categories. Schoenberg (2006), for example, argues that managers personal assessments provide information on both financial and non-financial indicators and thus capture performance in a more multidimensional way. However, Lubatkin and Shrieves (1986) argue that a manager s assessment might be subject to managerial bias, 6

8 which decreases the reliability of the data. McGee et al. (2005) argue that a company s goal is to maximize shareholder wealth and hence, stock price development is the optimal indicator of M&A performance. However, Zollo and Meier (2008) find evidence that the widely used short event window of stock-market-based studies only reflects, most often incorrect, investor expectations, whereas Chenhall and Langfield-Smith (2007) accuse accounting-based measures of capturing only a company s past performance. The above is only a glimpse of the ongoing debate on performance measurement in mergers and acquisitions. However, I leave this discussion to other researchers and focus on the research stream utilizing accounting-based performance measures, the single objective measure category applicable to privately held companies (Schoenberg, 2006). 2.1 Accounting-based studies on M&A performance Although the literature on stock price development is extensive, the empirical research on changes in operating performance following M&A transactions is limited and yields inconsistent results. 5 The existing accounting-based research can be grouped into three categories: studies reporting a significant decline in post-acquisition operating performance, studies documenting a significant improvement in post-acquisition performance and studies finding no significant change. Table 1 provides an overview of some of these studies. Part of the diversity in results can be explained by differences in the methods applied to measure operating performance, to scale the performance, to choose the benchmark (adjusting method) or to run the analysis, as is probably the case with the results of e.g. Healey et al. (1992) and Ghosh (2001). They use the exact same performance measure (pretax cash flow), scaling method (the adjusted market value of assets) and models (the change and intercept model), but apply different adjusting methods. Healey et al. (1992) adjust for 5 In general, stock-market-based studies document significant positive returns for target shareholders, significant negative long-term returns for acquirer shareholders and the results regarding the short-term returns for acquirer shareholders are inconclusive (Papadakis and Thanos, 2010). 7

9 industry and document an improvement in post-acquisition operating performance, whereas Gosh (2001) reports no significant change in operating performance, adjusting for industry, size and pre-event performance. However, in other cases the inconclusiveness of results cannot be explained by differences in methodology. Powell and Stark (2005) and Martynova et al. (2006), for example, employ the exact same methods but report a significant improvement and no significant change in post-acquisition operating performance, respectively. This suggests that the diversity in results might also be caused by differences in sample period, geographical region or sample size. 6 netheless, Powel and Stark (2005) and Martynova et al. (2006) depict a trend in which more recent studies, employing more sophisticated methods, tend to report no or positive significant changes in operating performance. [INSERT TABLE 1 ABOUT HERE] 2.2 The post-acquisition operating performance of privately held companies Besides the profitability of mergers and acquisitions, prior research also focuses on determining M&A success factors. However, one possibly important factor, the legal status of the acquirer, has received little attention. Moreover, it is my understanding that this is the first study to distinguish between the post-acquisition performance of privately held acquirers and publicly traded acquirers. The interest in the legal form of the acquirer as determinant of M&A performance lies in the difference in ownership structure. In general, privately held companies have a much more concentrated ownership structure than publicly traded companies. This enables more stringent control of the management, forcing it to engage only in value creating takeovers, as opposed to takeovers driven by managerial incentives (discussed in paragraph Managerial incentives). Hence, one would expect privately held 6 Sample size, for this matter, is only of importance when reporting no significant results, due to selection of a too small sample. 8

10 acquirers to be more successful in their M&A transaction than publicly traded acquirers. Besides comparing the post-acquisition performance of public and private acquirers, I also investigate M&A performance across acquirer s ultimate owners, a more detailed indicator of ownership structure. 7 Based on the literature on managerial incentives, I expect acquirers ultimately owned by an individual, family or management to outperform acquirers without ultimate owner Managerial incentives Since Berle and Means (1932) the conflict between shareholders and management, arising from the separation of ownership and control, is well recognized. Managers, as agents of shareholders, may make financial decisions that serve their own interests at the expense of the shareholders wealth. 9 These incentives can also play a role in M&A transactions. According to Gaughan (2003), shareholders must be aware of empire building, a situation in which managers use acquisitions to fulfill their desires of gaining power and reputation and improving future job chances. This type of acquisitions might seriously deteriorate shareholder wealth. Moreover, managers may unintentionally be stimulated to undertake negative net present value acquisitions when inappropriate compensation policies are in place (Harford and Li, 2007). Amihud and Lev (1981) state that when a manager s compensation is depending on the firm s earnings, there is an incentive to select diversifying investments to reduce fluctuations in these earnings. Undertaking conglomerate acquisitions is a well-known strategy to achieve such a diversified portfolio. However, such a strategy is in most cases not 7 Throughout this study the categorization of ultimate owners is based on the Bureau van Dijk (BvD) independence indicator. Although the BvD categorization contains 4 main categories, I employ only three categories; one in which companies are directly or indirectly owned (>50%) by an individual, family or management, one in which no individual, family or management directly or indirectly owns more than 50% of the company s shares and one containing companies of which the ownership structure is unknown. 8 If a company has no ultimate owner, the company is owned by either several unrelated individuals, none of them owning more than 50% of the shares, or another company (>50%) in which no individual, family or management owns more than 50%. In the latter case managerial incentives can play a role in the holding firm. 9 More recently Jensen and Meckling (1976) and Harris and Raviv (1979) study this field. 9

11 beneficial for the shareholders, since they can often form their own homemade portfolios with preferred degree of risk at less costs. In addition there is the potential of the so called underinvestment problem, where managers forgo positive NPV projects. For example, when a manager is planning on retiring before the investment pays off, he might forgo a promising acquisition to prevent the initial investment which negatively affects the company s current financials and thus the manager s current compensation. Despite the availability of several methods to reduce these managerial incentives, they are still seen as one of the deteriorating factors in takeover profitability. Park (2007), amongst others, finds that companies with misaligned managerial incentives are more active acquirers, with yet significantly worse post-acquisition operating performance. This is supported by Sudarsanam and Huang (2006), who state that greater sensitivity of a manager s wealth to the company s stock price changes and stock return volatility is associated with significantly better post-acquisition performance. 2.3 Classic determinants of post-acquisition operating performance The next few paragraphs discuss some classic determinants of M&A performance Domestic versus cross-border Hymer (1976) states that both acquirers and targets can benefit from cross-border acquisitions by taking advantage of imperfections in the international factor, capital and product markets. According to Eun et al. (1996), acquirers might also benefit from expanding their businesses into new markets and from internalizing the target s research and development capabilities. Furthermore, Martynova and Renneboog (2008) prove that differences in the acquirer s and target s corporate governance policies, resulting from differences in the domestic countries legal origins, have an important, mostly positive, impact on M&A performance. However, 10

12 Schoenberg (1999) states that cross-border post-acquisition performance may decrease, due to difficulties in capturing the expected synergies, resulting from cultural and regulatory differences between the acquirer and target. The evidence is mixed. Moeller and Schlingemann (2003) and Martynova and Renneboog (2006) report significantly lower announcement returns for cross-border deals than for domestic deals. In contrast, Martynova et al. (2006) report no significant difference in post-acquisition operating performance, whereas Gugler et al. (2003) find that cross-border deals significantly outperform domestic deals Focused versus diversifying Although diversifying takeovers, which were characteristic for the 1960s wave, are expected to create operational and/or financial synergies, they are also associated with numerous disadvantages (Sudarsanam, 2010). Rajan et al. (2000), for example, stipulate the danger of inefficient capital allocation resulting from the political process within the firm, and Schleifer and Vishny (1991) caution for increased agency problems. Both state that these disadvantages may outweigh the expected synergies and diminish operating performance. The evidence on this matter is inconclusive. Healey et al. (1992) and Heron and Lie (2002) document that diversifying takeovers are associated with significantly worse postacquisition operating performances, whereas Ghosh (2001) reports a positive connection. Martynova et al. (2006), Powell and Stark (2005) and Switzer (1996) find no significant difference in performance Relative target size Takeovers of relatively large targets have a greater scope for operational and financial synergies than takeovers of relatively small targets. Hence, the acquisitions of relatively large 11

13 targets are expected to outperform takeovers of relatively small targets. However, difficulties in integrating and managing a relatively large target may lead to deterioration of performance. Both conjectures are supported by empirical evidence. Linn and Switzer (2001) and Martynov et al. (2006), amongst others, report that takeovers of relatively large targets outperform those of relatively small targets. 10 In contrast, Clark and Ofek (1994) document higher post-acquisition performances for acquisitions of relatively small targets. However, most research finds no relation between relative target size and post-acquisition performance (e.g. Healey et al., 1992, Heron and Lie, 2002 and Powell and Stark, 2005) Acquirer s cash reserves Empirical evidence (Harford, 1999, Moeller and Schlingemann, 2004 and Martynova et al., 2006) shows that acquirers with excessive cash reserves perform significantly worse in their mergers and acquisitions than acquirers with less cash reserves. This is in line with Jensen s (1986) free cash flow theory, which states, on the basis of managerial incentive theory, that poor acquisitions are more likely to take place when managers have access to excessive cash holdings Acquirer s leverage The rationale behind leverage as determinant of takeover success lies in the monitoring by banks. A highly leveraged acquirer might be subject to strict bank monitoring, which makes it more likely that unprofitable acquisitions are prevented. Furthermore, funds to finance the takeover are harder (more costly) to obtain for companies that are already highly leveraged, decreasing the likelihood that acquisitions, especially unprofitable ones, take place. 10 When using quartiles based on relative target size, instead of dividing the sample into small and large subsamples using target sales of 20% of acquire sales as dividing criteria, Martynov et al. (2006) find that the increase in performance is non-linear. The third quartile outperforms both the first (relatively small targets) and fourth quartile (relatively large targets), which supports both the scope and the integration conjecture. 12

14 However, the empirical evidence is mixed. Some research (e.g. Harford, 1999) provides evidence in line with this rationale, while other research (e.g. Martynova et al., 2006 and Clark and Ofek, 1994) reports no significant relation Method of payment The empirical evidence on the method of payment as determinant of post-acquisition performance is mixed. Healey et al. (1992) and Martynova et al. (2006), for example, report no significant relation, whereas Linn and Switzer (2001) and Ghosh (2001), amongst others, find that takeovers paid for in cash are associated with stronger improvements in postacquisition operating performance than takeovers paid for in other forms. An explanation for the positive effect of cash payment on operating performance could be that cash payments are often financed with debt, imposing the mechanism explained in paragraph Acquirer s leverage (Martynova and Renneboog, 2006). Another explanation might be that a target s management, possibly underperforming, is more likely to be replaced when an acquisition is paid for in cash compared to other methods of payment (Parrino and Harris, 1999). 3. Data and Methodology 3.1 Sample selection I retrieve my sample of European mergers and acquisitions completed between 2003 and 2010 from the M&A database Zephyr. 11 Only domestic and cross-border takeovers in which both the acquirer and target are European are included. To facilitate comparison, both publicly traded and privately held acquirers are selected. in which either the acquirer or target is 11 The chosen time span results from the limitations on accounting data available in Orbis. For this research, I require at least one year of pre- and post-acquisition data, and since Orbis only contains data for the period 2002 to 2011, the sample is limited to include only deals completed between 2003 and

15 a government, financial institution, holding company or investment company are excluded. Furthermore, deals are required to have a minimum deal value of one million euro and companies that are engaged in more than one deal are omitted from the sample. 12 I supplement the retrieved dataset with accounting data collected from the Orbis database. For this study, I require availability of at least one year of pre-acquisition EBIT and total assets or total sales figures, for both the acquirer and target, and one year of consolidated post-acquisition data. 13 Furthermore, I collect data on inter alia, working capital, ultimate ownership, legal form, leverage, cash position, industry classification, country of origin and method of payment Sample description The final sample comprises 416 M&A deals (see Table 2), including 236 (57%) deals in which the acquirer is a publicly traded company and 180 (43%) deals in which the acquirer is a privately held company. In 51% (211) of the deals the acquirer is ultimately owned by an individual, family or management and in 44% (185) of the deals the acquirer has no ultimate owner. 15 These figures differ substantially between public and private companies. Respectively 30% (72) and 69% (162) of the publicly traded acquirers are ultimately owned by an individual or have no ultimate owner, compared to 77% (139) and 13% (23) of the privately held acquirers. This is not surprising, since it is well documented that publicly traded companies less often have one controlling shareholder. Other differences worth noting 12 Several companies acquired multiple targets during the sample period, or occurred in the sample as both acquirer and target, respectively. To avoid data interference, deals in which these companies were involved are omitted from the sample. 13 I collect at least one, but up to three years of both pre- and post-acquisition data. 14 I collect these figures to enable additional research, therefore availability of this data, except for the legal form of the acquirer, is no requirement. 15 The categorization of ultimate owners is based on the Bureau van Dijk (BvD) independence indicator. Although the BvD categorization contains 4 main categories, I employ only three categories; one in which companies are directly or indirectly owned (>50%) by an individual, family or management, on in which no individual, family or management directly or indirectly owns more than 50% of the company s shares and one containing companies of which the ownership structure is unknown. 14

16 are the differences in relative target size, acquirer cash reserves and geographical scope. Private acquirers takeover less relatively small targets (45%) and more relatively large targets (28%) compared to public acquirers (65% and 15%, respectively). 16 Furthermore, privately held acquirers undertake relatively more cross-border deals, 85% compared to 72% of the public acquirers, and have smaller cash reserves, 48% of the private acquirers has less than 5% cash reserves compared to 31% of the public acquirers. 17 Most other sample statistics do not exhibit substantial differences between publicly traded and privately held acquirers. In about 89% (371) of the deals the target is a privately held company, around 28% (118) of the acquisitions is paid for in cash and about 63% (262) of the acquisitions is diversifying. 18 What is striking however, is the extremely limited availability of private acquirer leverage data, for only 3 private acquirers this data is available. 19 [INSERT TABLE 2 ABOUT HERE] 3.3 Selection of peer companies By measuring the changes in operating performance without using a benchmark the results may be biased. Part of the change in operating performance might be generated by economy wide developments, industry specific developments or other factors beyond management s control. In other words, I need to compare the pre- and post-acquisition performance as if the takeover has not taken place, and measure only the abnormal change in operating performance. In order to achieve this, the literature suggests several adjustments. Healy et al. (1992) were the first to suggest an adjustment for industry trend. Rahman and Limmack 16 Relative target size is defined as the target s book value of total assets divided by the acquirer s book value of total assets, measured one year prior to the acquisition. 17 Cash reserves is defined as the acquirer s cash and cash equivalents divided by the acquirer s book value of total assets, measured one year prior to the acquisition. 18 Takeover strategy is defined by the acquirer s and target s primary 2-digit NACE Rev. 2 economic activity codes. 19 Leverage is defined as the acquirer s book value of total debt and liabilities divided by the acquirer s book value of total assets, measured one year prior to the acquisition 15

17 (2004) suggest to adjust for industry trend and company size. Alternatively, Barber and Lyon (1996) suggest to add a third adjustment, a pre-acquisition performance measure. Martynova et al. (2006) adjust both for industry (SIC-code) alone and industry, size (total assets) and preacquisition performance (EBITDA over total assets), and show that in most cases the results are not significantly different. Based on the above and additional literature, I decided to adjust for industry and size using the Standard Peer Group function in Orbis. Based on a company s primary NACE Rev. 2 economic activity code and its operating revenue over turnover, this function constructs a group of 100 peer companies for each individual company. 20 From these groups I collect median data to use as company specific benchmarks. 3.4 Measures of operating performance Most studies on post-acquisition operating performance use EBITDA, pre-tax operating cash flow, as measure of operating performance (e.g. Healy et al., 1992, Heron and Lie, 2002). Researchers agree that, since it is the sum of operating income, depreciation, interest expense and taxes, such a performance measure is unaffected by differences in financial structure and applied accounting method in computing depreciation, interest and taxes, making it a pure operating performance measure. To establish a measure of operating performance that is comparable across firms, Healey et al. (1992) divide this measure by the market value of total assets. 21 Alternatively, Clark and Ofek (1994) scale their performance measure (EBITD) by sales. 20 All figures used in constructing the peer groups are measured one year prior to the acquisitions. Furthermore, the Standard Peer Group -function considers three different methods in calculating operating revenue over turnover; as reported, total assets times the median value of turnover per employee of the industry over the median value of total assets per employee of the industry, and the number of employees times the median industry value of the turnover per employee. The highest of these value is used as size classification. 21 Healy et al. (1992) argue that by scaling their performance measure by the market value of total assets, in contrast to scaling by the book value of total assets, the measure is unaffected by the method of accounting for the acquisition. However, since the European accounting regulation (IAS) allows only the purchase method to account for mergers and acquisitions, this statement is irrelevant for this study. 16

18 Martynova et al. (2006) state that the often used EBITDA (earnings before interest, tax, depreciation and amortization) is not a pure cash flow performance measure, since it does not take into account changes in receivables, inventories and payables. Therefore, their study includes two different cash flow measures, namely EBITDA-only and EBITDA minus changes in working capital (ΔWC). They scale these measures by the book value of total assets (BVassets) and sales to create four performance measures that are comparable across firms. 22 I utilize these same performance measures. However, given the very limited availability of private acquirer depreciation and amortization data, and thus EBITDA figures (pre-acquisition EBITDA figures were available for only one private acquirer), I am forced to substitute EBIT (earnings before interest and tax), the next best measure, for EBITDA. Overall, I consider the following four measures of operating performance; (1) (EBIT ΔWC) / BVassets; (2) (EBIT ΔWC) / Sales; (3) EBIT / BVassets; (4) EBIT / Sales. In order to determine the change in operating performance following a takeover, I start with computing the unadjusted pre-acquisition operating performance of the combined firm. I calculate this by simply summing the acquirer s and target s cash flow measures and scaling this by the sum of their book values of total assets or sales figures 23 : combined firm t C A t C T t A A t A T t Secondly, I compute the peer pre-acquisition operating performance of the combined firm, as the weighted average of the acquirer s and target s peer companies profitability s, 22 Almost every study in the field uses some dominator to create a comparable measure, the book value of assets, the market value of assets and sales are most commonly used. 23 OP is used as short for operating performance, CF indicates one of the two, EBIT ΔWC or EBIT, cash flow measures and BASE indicates one of the two, BVassets or sales, scaling measures. 17

19 using the relative size of the acquirer s and target s book values of total assets or sales figures as weights: combined firm peer t A A t A A t A T t C peera t A peera t A T t A A t A T t C peert t A peert t Thirdly, I compute the post-acquisition operating performance of the combined firm, which is simply the realized cash flow measure of the consolidated firm scaled by the consolidated book value of total assets or sales figure: combined firm t C A t A A t Fourthly, I compute the peer post-acquisition operating performance of the combined firm in the same way I computed the peer pre-acquisition operating performance of the combined firm, only this time the weights are not the current book values of total assets or the current sales figures of the acquirer and target, but the values one year prior to the acquisition: combined firm peer t A A t A A t A T t C peer A t A peera t A T t A A t 1 A T t C peert t A peert t Finally, the combined firm s operating performance adjusted for industry and size can be calculated as the difference between the combined firm s performance and the combined peer s performance: OP t = combined firm t combined firm peer t 3.5 Methodology To assess the change in operating performance caused by the takeover, I employ the change model. For each firm, I estimate the change in performance as the difference between the median post-acquisition operating performance and the median pre-acquisition operating performance. 24 I apply a Wilcoxon signed rank test to test whether the median post- 24 At least one, but up to three years of both pre- and post-acquisition data is used in calculating the medians. 18

20 acquisition performance is significantly different from the median pre-acquisition performance. 25 As robustness check, I also asses the change in operating performance using the intercept model. I run a simple OLS regression, taking the median post-acquisition performance measure as dependent variable and the median pre-acquisition performance measure as independent variable. The intercept in the model captures the change in operating performance, while the coefficient reflects the relation between pre- and post-acquisition performance. A simple T-test is applied to test for significance of the intercept and the coefficient. As mentioned earlier, I also investigate some possible determinants of post-acquisition operating performance, amongst which the legal form of the acquirer carries the most interest in this study. For this purpose, I compare the median changes in operating performance of different categories of the variables, and apply chi-squared tests to test for significance of the differences. In case a variable is categorized into more than 2 categories, I apply two chisquared tests, one on the differences between all categories jointly and one on the difference between the two categories of most interest. Furthermore, I also employ a multivariate analysis to explore the combined effect of the determinants. I run several OLS regressions, using different performance measures and/or model specifications, and test for individual and joint significance of the variables using a simple T-test and F-test, respectively. 25 It is important to understand that, as a result of the way they are calculated, median differences are sometimes counterintuitive. A median difference is calculated as the median of differences, not by simply subtracting the median pre-acquisition performance from the median post-acquisition performance. As a result, the median difference might be a negative number, while, based on simply subtracting the median pre-acquisition performance from the median post-acquisition performance, one would expect a positive difference. 19

21 4. Empirical results 4.1 Does operating performance improve following M&A transactions? Table 4 presents the results of the change model applied on the complete sample and on two subsamples containing only private or public acquirers. Regarding the complete sample, comparison of the unadjusted ( raw ) pre- and post-acquisition performance shows that operating performance decreases substantially following takeovers, 3 out of 4 measures report significant declines ranging from -0.73% to -1.00%. This result is in line with Powell and Stark (2005) and Martynova et al. (2006), who both find that, in general, a company s unadjusted operating performance decreases significantly following a merger or acquisition. However, when looking at the industry and size adjusted changes in operating performance the results are less straight forward. The performance measures including changes in working capital ( pure cash flow measures) reveal no significant change in profitability, whereas the measures that don not include changes in working capital exhibit significant decreases in performance ranging from -0.83% to -1.60%. This result contradicts the findings of Rahman and Limmack (2004) and Powell and Stark (2005), who report improvements in operating performance for both the working capital adjusted and non-adjusted performance measures. On the other hand, the results are in line with Clark and Ofek (1994) and Kruse et al. (2002), who report negative results employing EBITD and pre-tax cash flow (both not adjusted for working capital) as performance measure, respectively. The results are also partly in line with Martynova et al. (2006), who document no significant change in operating performance for both the working capital adjusted and non-adjusted performance measures. [INSERT TABLE 4 ABOUT HERE] 20

22 4.2 Private versus public Regarding the private subsample, Table 4 shows that an acquirer s raw operating performance decreases substantially following a M&A transaction, which is comparable to the results of the complete sample. All four performance measures exhibit significant declines in performance ranging from -0.89% to -1.82%. In contrast, regarding the sample including only publicly traded companies, only one performance measure, EBIT divided by the book value of total assets, exhibits a significant negative change (-1.18%) in profitability. The other measures show no significant results. When relying on the industry and size adjusted performance measures, EBIT divided by the book value of total assets exhibits significant declines in post-acquisition performance for both public and private acquirers, whereas EBIT divided by sales reveals this same significant negative relation only for private acquirers. However, comparable to the complete sample, none of these relations remains significant when including changes in working capital in the performance measures. Based on the literature on managerial incentives one would expect to find that privately held acquirers significantly outperform publicly traded acquirers. However, based on the results presented in Table 4, the opposite appears to be the case. Table 5 shows the median changes in operating performance by legal form and the results of the chi-squared tests applied to test for significance of the differences. Although, as described above, several measures, both raw and adjusted for industry and size, report significant declines in operating performance for private acquirers while showing no significant changes in performance for public acquirers, none of these differences is statistically significant, not even at the 10% level. This suggests that either, in contrast to findings of Park (2007), managerial incentives are of less importance than assumed to be or are minimized effectively, or privately held 21

23 companies aren t monitored as thorough as they are expected to be, possibly due to owner incompetence. 26 [INSERT TABLE 5 ABOUT HERE] Table 6 supports these findings by showing that the median change in operating performance following takeovers does not, for all but one performance measure, significantly differ for different types of ultimate owners. [INSERT TABLE 6 ABOUT HERE] 4.3 Robustness check As robustness check, I examine whether the intercept model yields different conclusions than the change model. Table 13, panel A, presents the results. Strikingly, when comparing the unadjusted performance measures, in various cases the intercept model exhibits significant positive median changes in operating performance, while the change model reports (significant) declines in operating performance. However, much of this inconsistency disappears when you focus on the adjusted performance measures, which highlights the importance of the adjustment method employed and possibly explains some of the inconclusiveness of prior research. Although applying the intercept model on the adjusted performance measures yields roughly the same results as the change model, it is remarkable that the performance measures not including changes in working capital report no significant changes in the operating performance of private firms, whereas they do employing the change model. At the same time, the EBIT minus changes in working capital, scaled by assets, adjusted performance measure shows a significant decrease in private firm operating performance of no less than - 26 Although farfetched, it is also possible that an omitted variable has a stronger negative effect on the profitability of mergers and acquisitions undertaken by privately held acquirers than by public traded acquirers, offsetting the positive relation between privately held acquirers and M&A performance expected based on managerial incentive theory. 22

24 5.18%, compared to an insignificant -0.72% employing the change model. This, and the generally higher absolute changes in operating performance exhibited using the intercept model, can be explained by the structure of the models. The intercept model uses means of the median differences in its estimations, whereas the change model is based on medians of the median differences, making it less sensitive to outliers. Finally, the results in panel B of Table 13 show that the slope coefficients of 20 out of 24 regressions are positive and significant, which suggests that a company s post-acquisition operating performance is positively related to its pre-acquisition operating performance. [INSERT TABLE 13 ABOUT HERE] 4.4 Classic determinants of post-acquisition performance In this section I investigate the empirical implications of some classic determinants of postacquisition operating performance. Although the results of both the adjusted and unadjusted performance measures are presented, I focus on the adjusted performance measures. To examine the combined effect of the determinants, I end this section with a multivariate analysis Domestic versus cross-border Table 7 examines whether there is a relation between the geographical scope, domestic versus cross-border, of an acquisition and the post-acquisition performance of the combined firm. It shows that, when adjusted for industry and size, the median change in operating performance of publicly traded companies does not significantly differ between domestic and cross-border deals. In contrast, private companies seem to perform substantially better following crossborder acquisitions. Although this difference is only significant for one of the performance measures, the results are economically notable. However, caution must be taken in the 23

25 interpretation of these private acquirer figures, since the low number of domestic deals might distort the results. Overall, the results of Table 7, in line with Martynova et al. (2006), can best be interpreted as insignificant. [INSERT TABLE 7 ABOUT HERE] Focused versus diversifying Based on the acquirer s and target s primary 2-digit NACE Rev. 2 economic activity codes, I examine whether post-acquisition performance evolves differently following focusing versus diversifying mergers and acquisitions. Looking at the industry and size adjusted measures, Table 8 clearly shows that publicly traded companies engaged in diversifying takeovers significantly outperform public firms engaged in focusing takeovers. However, this positive relation between diversifying takeovers and post-acquisition performance seems not to hold, not even insignificantly, for private acquirers. When including privately held companies in the sample, only one, of the previous three, performance measure remains significantly different across takeover strategy. Overall, I can only conclude that, although it depends on the legal form of the acquirer, diversifying takeovers are associated with higher post-acquisition performance. This result is in line with Ghosh (2001). [INSERT TABLE 8 ABOUT HERE] Relative target size To test whether the relative size of the target is an important factor in M&A transactions, I split the sample into quartiles based on the target s book value of total assets relative to the acquirer s book value of total assets. Table 9 presents the results. It is striking that the performance measures including changes in working capital report fairly different results than the measures excluding changes in working capital. Although often insignificant, the pure measures suggest a positive relation between relative target size and post-acquisition 24

26 performance, whereas the non-pure performance measures exhibit more random results. 27 This contrast indicates the importance of choosing the most appropriate performance measure and might explain some of the contradictory results in the literature. The pure cash flow measures results are in line with Linn and Switzer (2001) and Switzer (1996) and suggest that the relatively large operational and financial synergies, achievable when acquiring relatively large targets, outweigh the concerns regarding difficulties in integrating and managing relatively large target firms. [INSERT TABLE 9 ABOUT HERE] Acquirer s cash reserves To test Jensen s (1986) free cash flow theory, which predicts that cash-rich firms are more likely to be engaged in poor takeovers, I compare the post-acquisition performances of the combined firms across quartiles based on the acquirers pre-acquisition relative cash reserves. Table 10 shows, especially for the working capital adjusted performance measures, that, although often insignificant, acquirers with large cash reserves indeed tend to perform worse in their mergers and acquisitions. 28 This is in line with Martynova et al. (2006), who document an insignificant negative relation between cash reserves and post-acquisition operating performance. [INSERT TABLE 10 ABOUT HERE] Acquirer s leverage 29 In line with Harford (1999), Table 11 clearly shows that acquirers with very high levels of leverage (fourth quartile) significantly outperform acquirers with very low levels of leverage 27 tice that the first two quartiles of the private acquirer subsample and the fourth quartile of the public acquirer subsample contain very limited numbers of observations, which makes the results of these subsamples less reliable. However, when focusing on the complete sample, with the observations evenly distributed over the quartiles, the same pattern of results is observable. 28 tice that the last two quartiles of the private acquirer subsample and the first quartile of the public acquirer subsample contain limited numbers of observations, which makes the results of these subsamples less reliable. However, when focusing on the complete sample, with the observations evenly distributed over the quartiles, the same pattern of results is observable. 29 Table 2 already showed that the sample contains almost no leverage data for private acquirers, therefore I investigate the effect of leverage only for the complete sample 25