Determinants of abnormal returns in mergers and acquisitions: macroeconomic factors

Transcription

1 Determinants of abnormal returns in mergers and acquisitions: macroeconomic factors Name Robin Ketelaars ANR S Date Supervisor V.P. Ioannidou Tilburg university Master Thesis Finance Faculty of Economics & Business Administration Department of Finance 1

2 Abstract This research aims to determine whether or not macroeconomic factors have an influence on the abnormal equity returns that accompany mergers and acquisitions. This will be tested using an event study and an ordinary least squares regression, executed on a sample of 1734 mergers and acquisitions between January 2001 and August It is shown that the data used in this research is partially in line with prior research. Five macroeconomic factors will be investigated. These factors are consumer price index, producer price index, a monetary aggregate, the interest rate and the investment level in the economy. This research shows that some of these factors have a statistically significant influence on the level of abnormal equity returns. The results show that a favorable state of the economy contributes to higher abnormal returns. The effect of the macroeconomic factors is different for acquiring companies than for target companies. This shows that a certain state of the economy does not equally benefits or harms acquiring and target companies. 2

3 Table of Contents Abstract Introduction Theoretical framework General introduction to mergers and acquisitions Mergers and acquisitions Abnormal returns Evidence on mergers and acquisitions Long run performance Motives for mergers and acquisitions Evidence on abnormal returns Investor Sentiment Macroeconomic factors Research question and methodology Hypotheses formulation Research plan Data resources Results and hypotheses review Sample Statistics Empirical analysis and results Abnormal returns Wealth effect Macroeconomic factors Hypotheses review Concluding remarks Bibliography

4 1. Introduction Acquisitions and mergers have become an important method for businesses to expand. In 2001, 8309 mergers and acquisitions were announced by U.S companies, with a value exceeding $700 billion. However, these amounts were even lower than the preceding years. In 2000, 1999 and 1998 the total value of merger and acquisition deals were $1.28 trillion, $1.4 trillion and $1.2 trillion respectively. The topic of mergers has been broadly covered in the existing literature. Nelson (1959) for example states that the merging of enterprises exists as long as humans have started to form enterprises. However, the type of mergers and acquisitions that can cover entire industries as we know them today did not occur until the 1890 s. Nelson (1959) identifies three major merger waves in the United States. He states that the first large merger wave took place from 1898 to 1902, the second wave from 1926 to 1930 and the third wave from 1946 to Lamoreaux (1985) states that the merger wave of the late 19 th century took place between 1895 and She states that the consolidation of Standard Oil Trust in 1882 was the first consolidation ever documented. Furthermore, in accordance with Nelson (1959), Lamoreaux (1985) argues that the passage of the general incorporation law in New Jersey in 1888 served as a boost to the first large merger wave of the late 19 th century. More recently, Holmstrom and Kaplan (2001), among others, discuss the merger waves of the 1980 s and the 1990 s. Martynova and Renneboog (2008) also discuss the historical U.S. merger waves and state that there is a clear pattern: the beginning of all five documented merger waves in history coincided with economic prosperity and economic recovery, whereas the end of every merger wave coincided with a stock market crash. This may indicate that macroeconomic factors, which determine the state of the economy, have an influence on the presence or absence of merger waves. In the last few decades, focus of academic research has shifted more towards the behavioral finance and the psychology of economics. It has become more and more apparent that the classical economic theories are inadequate in explaining certain outcomes. For example, as opposed by the classical theories, investors and managers are only rarely fully rational in decision making. This bounded rationality has an effect on economic decisions and their outcomes. This paper researches the abnormal returns of equity shares that come with mergers and acquisitions. It may be possible that investors who are not fully rational overreact to changes in macroeconomic factors or are guided in their investment decisions by general under- or overconfidence. As stated above, merger waves coincided with periods of economic prosperity. As will be argued below, this suggests that managers can time their corporate decisions on mergers and acquisitions to execute these decisions in periods when the economy is in a favorable state. It can be expected that managers time these decisions to accomplish the maximum gain for their shareholders. Investors are willing to pay more for equity shares when the economy is strong. Therefore it is to be expected that factors that portray a strong economy such as low inflation, a low interest rate and a high level of investment in the economy have a positive effect on the abnormal returns. The goal of this paper is to determine if macroeconomic factors have any influence on abnormal returns and if so to determine the level and significance of this effect. By answering this question, this paper can provide evidence on whether or not the timing of mergers and acquisitions in times of economic prosperity is justified. Moreover, by determining the extent of the possible 4

5 impact of macroeconomic factors on abnormal returns, this research can support investors and managers in their expectation of the extent of the abnormal returns. To accomplish this, a sample of mergers and acquisitions and the accompanying abnormal returns will be investigated. Some control variables will be added to make it possible to check the outcomes of this research with prior academic work. This paper is organized as follows: Chapter two will review prior academic work on different topics that are of importance for this research. Chapter three will contain the methodology, the sample of mergers and acquisitions and the data. Chapter four will describe the analyses and will contain a review of the results. Finally, chapter five will contain some concluding remarks. 5

6 2. Theoretical framework 2.1 General introduction to mergers and acquisitions Mergers and acquisitions Since the first merger wave in the late 19 th century, mergers and acquisitions have evolved in one of the most important, if not the most important method for businesses to expand rapidly. There are only slight differences between the two terms. According to the Farlex Financial Dictionary, a merger is defined as follows: A decision by two companies to combine all operations, officers, structure, and other functions of business. Mergers are meant to be mutually beneficial for the parties involved. Through a merger, two (or more) companies mutually decide to form a new corporation. Both companies will cease to exist and new shares of stock of the newly formed company will be issued. Shareholders of the two old companies will be offered to substitute their shares of the old company for share of the new corporation. A horizontal merger is a merger where two companies in the same industry engage in a merger. Mostly this type of merger is to realize more efficiencies of scale or to realize greater market share. Vertical mergers are mergers where two companies in the same supply chain engage in a merger. A well-known merger for example is the 1999 merger of Glaxo Wellcome and SmithKline Beecham, who together formed GlaxoSmithKline. More well-known mergers are the 2002 merger of Hewlett-Packard with Compaq Computers and the 2000 merger of America Online with Time Warner. The Farlex Financial Dictionary defines an acquisition as: An investment in which a company or person buys a publicly-traded company, or, more commonly, most of the shares in that company. For example, if Corporation A buys 51% or more of Corporation B, then Corporation B becomes a subsidiary of Corporation A, and the activity is called an acquisition. Acquisitions occur in exchange for cash, stock, or both. Acquisitions may be friendly or hostile; a friendly acquisition occurs when the board of directors supports the acquisition and a hostile acquisition occurs when it does not. In an acquisition, the target company does not have to support the acquisition of shares of stock by the bidding company. If the bidding company acquires 100 percent of the shares of the target company, the target company becomes a subsidiary of the bidding company and since the bidding company holds all the shares of the target company, the shares of the target company will cease to trade. The most significant difference between mergers and acquisitions is thus that in a merger, both companies involved will cease to exist and a new company is formed, whereas in an acquisition, both companies continue to exist. Moreover, in a merger both companies will have to agree to engage in a merger, whereas in an acquisition, the target company may not approve the acquisition but can be 6

7 unable to prevent it. However, in this paper these differences are not significant. This paper focuses on the abnormal returns on equity shares involved in mergers and acquisitions Abnormal returns Abnormal returns are defined as the excess returns of a stock compared to the expected rate of return. Abnormal returns normally occur due to announcements from or about the corporation. Financial restatement announcements, mergers and acquisitions, stock split announcements etc. Fama et al. (1969) first looked at these abnormal returns. They investigated the rate of returns in the months surrounding stock splits. Fama et al. (1969) stated that the residual returns on stocks of companies that announced a stock split were abnormally high surrounding the announcement date. To compute these results they introduced the event study research method. This method considers the relationship of a stock with the market to compute an expected rate of return. If the realized return deviates from this expected return, one can speak of abnormal returns, which can be both positive or negative. In this paper, an event study will also be used to compute abnormal returns. More details on the event study research method will be discussed in section Evidence on mergers and acquisitions Long run performance A company engages into a merger or acquisition in the hopes of benefitting from several factors. These factors can be but financial or strategic. More details about the motives of why companies engage in mergers or acquisitions will be discussed below Increase in Long run performance Even though decreases in long term performance following mergers and acquisitions is broadly found in the existing literature, increases in long term performance have also been well documented. For instance, Healy et al. (1992) investigated the 5 year post-merger performance of mergers in the US industry between 1979 and 1984 and found that the asset productivity, operating cash flow returns and the asset turnover increased. Linn and Switzer (2001) also investigated mergers in the US industry and found an increase in cash flow divided by market value over a 5 year post-merger performance for mergers between 1967 and Ghosh (2001) found an increase in cash flow returns to assets over a 3 year post-merger period for mergers between 1981 and 1995 in the US. Cosh et al. (1980) found an increase in growth of net assets and an increase in leverage ratio over a 5 year post-merger period for mergers between 1967 and 1969 in the UK, and Powell and Stark (2005) investigated mergers between 1985 and 1993 in that same industry and found an increase in cash 7

8 flow to total market value, an increase in cash flow to book value and an increase in cash flow to sales over a 3 year post-merger period. Kumps and Wtterwulghe (1980) investigated Belgian mergers between 1962 and 1974 over a 5 year post-merger period and found increases in net income to equity, net income to total assets and an increase in total assets growth rate Decrease in Long run performance Even though companies expect to benefit from a merger of acquisition in the future, a merger or acquisition may turn out to be less beneficial then expected beforehand. Many economists have researched the different merger waves in history and the results show that the expected increase in performance is not always realized. Martynova and Renneboog (2008) summarize some of the literature on post-merger performance. There have been several academics who investigated the long run performance during the 1960 s merger wave. Mueller (1980) investigated mergers and acquisitions and the 3 to 5 year post-merger performance of companies in the US from 1962 until 1972 and found a decrease in, amongst others, return on equity, return on assets, return on sales and a decreased sales growth rate. Mueller (1985) also investigated annual averages from 1950 until 1972 for companies that engaged in a merger and found a drop in market share. Jenny and Weber (1978) researched mergers and acquisitions and the 4 year post-merger performance in France over the same period as Mueller (1980) and found decreases in profit per equity, profit per asset, profit per sale and a decreased sales growth rate. Peer (1980) researched mergers and acquisitions in The Netherlands from 1962 until 1973 and found amongst others decreases in return on sales, return on equity and a lower total assets growth rate. Ryden and Edberg (1980) researched the merger and acquisition period in Sweden and also found decreases in return on equity, return on assets and return on sales in a 3 year post-merger period. Ikeda and Doi (1983) investigated the 3 year post-merger performance of mergers and acquisitions between 1964 and 1975 and also found a decrease in return on equity, whereas, amongst others, return on assets and sales growth remained at the same level as before the merger. Moreover, Meeks (1977) researched long run performance of mergers and acquisitions in the UK over a 3 year and 5 year post-merger period and found a decrease in EBIT divided by net assets. The long run performance for mergers and acquisitions in the merger wave of the 1980 s and the 1990 s has also been researched extensively. Clark and Ofek (1994) for instance researched the 2 year post-merger performance of mergers in the US and found a decrease in earnings before interest, taxes and depreciation (EBITD) divided by revenues. Odagiri and Hase (1989) investigated Japanese mergers between 1980 and 1987 and their 3 year post-merger performance and found a decrease in gross profit divided by assets and a lower sales growth for horizontal mergers and acquisitions. Carline et al. (2002) researched mergers in the UK and found a decrease in earnings before interest, taxes, depreciation and amortization (EBITDA) divided by the market value over a 5 year post-merger period for mergers between 1985 and Gugler et al. (2002) conducted a worldwide investigation on mergers between 1981 and They found a decrease in sales divided by assets for all deals investigated worldwide over a 5 year post-merger period and a decrease in profit divided by assets for merger deals in Japan. 8

9 As shown above, there has been a lot of scientific research on the long term performance of mergers and acquisitions. Even though companies engage in a merger or acquisition with the expectation to realize better performance in the future, it has been well documented that a better performance is often not the case. However, the academic work that focused on long term performance which is summarized above, did not focus on the factors that determine whether long run performance increased or decreased. Moreover, Martynova and Renneboog (2008) state that the results of the prior literature, combined with the result that the share price of the acquiring firm drops substantially in the 5 years following the acquisition, suggest that the gains companies hope to realize through a merger or acquisition are overstated Motives for mergers and acquisitions There are many reasons why companies decide to engage in a merger or acquisition. One of these reasons may for example be that the two companies combined can realize more efficient production, or benefit from each other s know-how. Yagil (1996) states that, based on prior literature, there are two main types of motives for managers to engage in a merger or acquisition: Financial motives and operating motives. Under operating motives, Yagil (1996) names improving market control and operating efficiencies, enhancing growth and to pool the resources of the two companies together to increase technological expertise. He states diversification, reducing the risk of bankruptcy and the accompanying costs and tax benefits are financial motives for mergers and acquisitions. Gugler, Mueller and Yurtoglu (2006) state that there are two main reasons for mergers and acquisitions: (1) following the neoclassical theories, mergers and acquisitions are initiated to maximize profits and shareholder wealth and (2) following the non-neoclassical theories, mergers and acquisitions are initiated for other reasons than to maximize shareholder value. Bruner (2001) states that the motives why companies engage into mergers or acquisitions that the motives for these decisions may be of strategic benefit and do not create wealth for the shareholders. He even states that some mergers and acquisitions take place for the sole reason that the two companies or the CEOs of the two companies are very friendly. These motives are no guarantee that the mergers or acquisitions will be beneficial. Capron and Pistre (2002) also name some motives such as industry overcapacity, financial diversification and preemption. These motives do not enhance shareholder value per se. Martynova and Renneboog (2008) argue that herding behavior is also a reason for managers to engage in mergers and acquisitions. They state that if a company accomplishes a successful merger or acquisitions, other companies are likely to follow in the same actions. These following mergers and acquisitions are not so much based on a clear economic perspective, but they are engaged to copy the actions of the first company to successfully engage in a merger or acquisitions. Amihud and Lev (1981) state that diversification is based on the incentive of the manager for risk reduction. However, in perfect capital markets risk reduction is not beneficial for the shareholders of the company, since they can diversify their own portfolio of equity shares to minimize the risk they bear. Even so, Amihud and Lev (1981) found evidence that managercontrolled firms engage more in diversifying mergers and acquisitions than owner-controlled firms. 9

10 2.2.3 Evidence on abnormal returns Extensive research has been conducted on the effects of mergers and acquisitions, both for the acquiring firm and the target firm, as well as for its shareholders and bondholders. Abnormal returns are defined as the excess return of a stock compared to the expected return. Researchers have aimed to provide evidence on which factors influence abnormal returns and which do not. Billett, King and Mauer (2004) for example state that significant positive announcement period returns are earned by target bonds that are below investment grade. Capron and Pistre (2002) investigate the post-acquisition transfer of internal resources between acquiring and target company. These internal resources are divided in three categories: innovation resources, marketing resources and managerial resources. They find that the acquiring company cannot earn abnormal returns when the company merely transfers internal resources from the target company to their own company. They state that the abnormal returns that would have been earned by only transferring resources from the target company to the acquiring company would have been competed away by other bidding companies, since those companies would have been equally capable of capturing those resources. Instead they state that the acquiring company should transfer its own managerial and innovative resources into the target company and utilize the target s own marketing resources. Fuller, Netter and Stegemoller (2002) investigated acquisitions and concluded that shareholders of the acquiring firm gain when the acquiring firm bought a private firm or subsidiary of a public firm and they lose when the acquiring firm bought a public firm. Furthermore, they stated that the absolute value of the gain or loss would be greater if the size of the target was larger and when the acquiring firm used stock to finance the acquisition. Mulherin and Boone (2000) also differentiated between abnormal returns to the shareholders of the acquiring company and abnormal returns to the shareholders of the target company. They found that the shareholders of the target company experienced an abnormal return of 20.2%, while the shareholders of the acquiring company faced an abnormal return of -0.37%. Although the abnormal returns to the shareholders of the acquiring companies were not significant, the abnormal returns to the shareholders of the target companies were significant. Andrade, Mitchell and Stafford (2001) found an averaged 16% abnormal return for target firms during a three-day event window compared to a -0.7% abnormal return for acquiring firms during that same event window. Bruner (2001) presents an overview of prior research concerning abnormal returns. All the research summed up came to the following conclusion: the cumulative abnormal returns for the shareholders of the target firm are on average significantly positive. Bradley, Desai and Kim (1988) for instance found cumulative abnormal returns of 31.77% between 1963 and Servaes (1991) researched mergers between 1972 and 1987 and found cumulative abnormal returns of 23.64%. Schwert (1996) investigated roughly the same period, from 1975 until 1991 and found abnormal returns for the shareholders of the target company of 26.3%. DeLong (2001) investigated deals between 1988 and 1995 where at least one of the involved parties was a bank and found abnormal returns of 16.61%. Bruner (2001) sums up even more prior literature and all research summed up concludes that cumulative abnormal returns to the shareholders of the target company are significantly positive. However, the results on the abnormal returns to the shareholders of the acquiring companies are not as unanimous as the results on the target companies. For instance, Asquith, Bruner and Mullins (1987) find cumulative abnormal returns for the shareholders of the acquiring companies of -0.85% 10

11 between 1973 and Jennings and Mazzeo (1991) find abnormal returns of -0.8% for deals between 1979 and Walker (2000) researched deals between 1980 and 1996 and found abnormal returns of -0.84%. Houston et al. (2001) investigated deals where both parties were banks and found abnormal returns of -4.64% for deals between 1985 and 1990 and abnormal returns of -2.61% for deals between 1991 and On the other hand however, there is also academic work that reports positive cumulative abnormal returns to the shareholders of the acquiring company. For instance, Kummer and Hoffmeister (1978) found positive cumulative abnormal returns of 5.20% for deals between 1956 and Jarrel, Brickley and Netter (1987) researched deals between 1962 and 1985 and reported abnormal returns of 1.14%. Loderer and Martin (1990) found abnormal returns of 1.72% between 1966 and 1968 and abnormal returns of 0.57% between 1968 and This shows that there is consensus in the literature about the abnormal returns to shareholders of the target company, but that the results on abnormal returns to the shareholders of the acquiring company are much less unanimous. On the other hand, all academic work summarized by Bruner (2001) report a positive wealth effect. This means that the combined returns to shareholders of the bidding firm and the target firm are positive. 2.3 Investor Sentiment Behavioral finance has been a rising topic in the academic literature over the last decades. In the classic financial theories, shareholders are expected to be fully rational. However, economists have become more and more aware that this is not the case. Baker and Wurgler (2006) investigate the effect of investor sentiment on cross-sectional stock returns and offer a possible definition of investor sentiment: investor sentiment is the tendency to speculate. They state that under this definition, the relative demand for speculative investments is driven by investor sentiment. Another explanation may be the optimism or pessimism about stocks in general. Daniel, Hirshleifer and Subrahmanyam (1998) have developed a theory based on overconfidence of investors and biased self-attribution that leads to changes in confidence. They state that this theory implies that private information causes investors to overreact and that public information causes investors to underreact. Barberis, Schleifer and Vishny (1998) have created a model for investor sentiment. The model shows how investors form beliefs about future earnings and is based on psychological evidence. They classify different types of news by two categories: the strength and the statistical weight of the news. In their paper, they argue that investors pay too much attention to the strength of the news, and too little attention to its statistical weight. However, they could only classify the news in hindsight. The model is not suited to classify the strength and the statistical weight a priori. Helwege and Liang (2004) investigate market cycles of initial public offerings (IPOs) between 1975 and They looked at characteristics and possible differences in these characteristics of hot and cold IPO markets. Helwege and Liang (2004) define a hot IPO market as experiencing severe underpicing, frequent oversubscription of offerings, an unusually high number of IPOs and at times concentrations in particular industries. Cold IPO markets on the other hand are defined as having less underpricing, lower amount of oversubscription of offerings and much lower volume of IPOs. The results show that the characteristics of firms that go public in a hot market do not differ so much from firms that go public in cold markets. Moreover, the results show that there are only slight 11

12 differences in profits, age of the firm or growth potential. Finally, Helwege and Liang (2004) state that hot markets are not caused by changes in for example managerial opportunism or technological innovations, but rather that hot IPO markets are the results of greater investor optimism. Ljungqvist, Nanda and Singh (2006) also investigate investor sentiment in initial public offerings. They created a model which shows that return anomalies such as underprcing, hot IPO markets and long-run underperformance can be traced to a common source, namely irrational investors. They also show that issuers can take advantage of the presence of irrational investors. This implies that managers can time the moment of issuance to maximize the gains of the offering. Baker and Wurgler (2006) investigate how investor sentiment influences the cross-sectional returns on stocks. They predict that investor sentiment plays a greater role in securities of companies that are more difficult to valuate. For their research, they created a proxy of investor sentiment based on six factors: the closed-end fund discount, the share turnover on the New York Stock Exchange, the dividend premium, the equity share in new issues, the number of IPOs and the average first-day returns on IPOs. It is interesting to notice that the number of IPOs is considered a determinant of the level of investor sentiment. As stated above, Ljungqvist, Nanda and Singh (2006) stated that managers can benefit from the presence of investor sentiment when their company engages in an IPO. Therefore it was argued that managers can time the moment of issuance so to benefit the most from the offering. The fact that Baker and Wurgler (2006) include the number of IPOs as a determinant for the investor sentiment proxy supports this statement. Based on the results, Baker and Wurgler (2006) state that future cross-sectional stock returns depend on the begin-of-period proxy for investor sentiment. The results show that stocks which are interesting for speculators earn relatively low returns when it is estimated that investor sentiment is high. Thus they have shown that investor sentiment does play a role in the cross-sectional returns on certain stocks. Tetlock (2007) investigates the effect of media on the stock market. Using news from a Wall Street Journal column, he finds that market prices are likely to decline when pessimism in the media is high. Moreover, he argues that extremely high or low pessimism predicts a high trading volume. Ozoguz (2008) investigates the effect of the beliefs and uncertainty of investors. She uses a model which uses the state of the economy to describe investors beliefs and uncertainties and market returns. The results show that investors beliefs and uncertainties are very successful when it comes to explaining large cross-sectional variations in portfolio returns. She also finds a negative relationship between investors uncertainty and the valuation of assets, and that the level of uncertainty varies strongly depending on the state of the economy. Moreover, the results show that investors beliefs also have an impact on the valuation of assets. When investors perceive that they are economically in a bad time, these beliefs have a negative impact on the prices of assets. Schleifer and Vishny (2003) investigated the role of stock mispricing in the takeover market. They produce a model to investigate stock market driven acquisitions. One of their conclusions is that managers can benefit from an overvaluation of the equity shares of the company. Managers have an incentive to achieve an overvalued stock, and once the equity shares of the company are overvalued, managers can use these shares as a currency to pay for acquisitions and mergers of relatively less overvalued targets. Say for example that company A and B both have a stock which is worth $25 and the stock of company A sells for $50 and the stock of company B sells for $40. Company A can then use its stock to pay for company B. if both stocks were priced correctly, company A has to pay one share per share of company B. however, since both companies are overpriced, and company A is overpriced more than company B, but companies will have an incentive to participate in the deal. On 12

13 the other hand, the long run performance of overvalued bidding companies is lower than the performance of bidding companies that are more accurately valuated. Schleifer and Vischny (2003) speak of the performance extrapolation hypothesis. This states that the future earnings of overvalued bidding companies are extrapolated wrongly by the market, which leads to a false view on the combined value of the firms post-merger. This is more or less the same as what happened in the merger between AOL and Time Warner in Steve Case, CEO of AOL, used the equity shares of AOL, which were highly overvalued, to pay for the merger with Time Warner. The total amount paid by AOL was $164 billion. When the dot-com bubble burst, the value of the combined firm AOL Time Warner dropped from $226 billion to around $20 billion. This shows how investor sentiment and overvaluation can drive the stock price of a company. Dong et al. (2006) examined the misvaluation hypothesis, which states that the takeover market is driven by misvaluations. Some results immediately stand out: Bidding companies are relatively higher valued than the target companies. Also, the higher the bidding company is valued by the market, the more likely it is that the company will prefer to use stock as the method of payment, and the less likely the company is to use cash as a currency. Moreover, the higher the bidding company is valued, the more it is willing to pay for the target company. Intuitively this makes sense. When the stock of the bidding company is highly overvalued, the manager can use stock as a currency, but this currency does not have real value since it is likely to drop again when the overvaluation becomes apparent. Dong et al. (2006) conclude with the statement that, according to their findings, the takeover market is indeed driven by misvaluations. Rosen (2003) investigated the investor sentiment involved in stock market reactions and focused the effects of mergers on the stock prices of the bidding firms. His research was based on three theories. First, the neoclassical theory states that the only goal of managers is the enhance shareholder value. Merger momentum could in this case arise from the fact that shocks in the market produce opportunities for bidding firms to increase the value and performance of the firm through a merger or acquisition. A second theory assumes that managers can engage in mergers without the aim of enhancing shareholder value, but that mergers are initiated based on operating motives. This could include motives as diversification and empire building. Lastly, he mentions the possibility that reactions on merger announcements are not based on fundamentals but rather on overly optimistic beliefs from managers or shareholders. He found evidence of a momentum factor in the merger markets: If prior merger announcements received a favorable reaction, later merger announcements tend to continue to do so. On the other hand, he also found evidence that the favorable short-term reaction is revised in the long run. Mergers that received a too favorable reaction surrounding the announcement, showed a decline in the stock price of the bidding company in the long run. This shows that the merger was overvalued at the time of the announcement, and that the overvaluation was corrected in the long run when the mispricing became apparent. This shows that investor sentiment is an important factor in the reaction that the equity shares of the bidding company receive by the market surrounding the merger announcement. 2.4 Macroeconomic factors As described above, academic research has been focusing more and more on the psychological aspects of finance than before. However, the determinants of investor sentiment have not had much attention. Baker and Wurgler (2006) created a measure based on six proxies for investor sentiment, 13

14 but they also state that these proxies are not definitive or uncontroversial. The rest of the academic work described above acknowledges the impact of investor sentiment, but does not aim to determine the causes of it. The approximation on investor sentiment is only reviewing or rather theoretical. That is, the results do not provide clear quantitative results as to what extent investor sentiment influences stock trading. Kwon and Song (2011) conducted research on the Korean merger market. One of the two most important conclusions of their work is that the global financial crisis has a significant negative impact on the cumulative abnormal returns of the bidding company when the merger is announced. As explanation they state that it may be possible that investors do not appreciate the large outflows of cash during a period of crisis. Martynova and Renneboog (2008) reviewed the history of merger waves and identified 5 major merger waves. The events coinciding with the beginning and ending of all merger waves show some striking resemblance. According to Martynova and Renneboog (2008), the first merger wave took place from the late 19 th century until The beginning of the merger wave coincided with economic expansion due to industrialization and the development of trading on the New York Stock Exchange, whereas the end of the merger wave coincided with a stock market crash and the beginning of the First World War. The second merger wave took place from the late 1910s until The start of the merger wave coincided with economic recovery of the stock market crash and the First World War, and the ending of the merger wave coincided with a stock market crash and the beginning of the Great Depression. The third merger wave started in the 1950s, coinciding with economic recovery after the Second World War and ended in 1973, coinciding with the stock market crash due to the oil crisis. The fourth merger started in 1981, during economic recovery from the oil crisis and ended in 1989 when another stock market crash took place. Finally, the fifth merger wave took place from 1993 until The beginning of the last wave coincided with economic boom and the globalization process and ended with the stock market crash in The pattern in merger waves is apparent: the beginning of all five documented merger waves in history coincided with economic prosperity and economic recovery, whereas the end of every merger wave coincided with a stock market crash. This shows that it is very likely that (macro) economic factors influence whether or not the economy is experiencing a merger wave, and thus influence the decisions of managers whether or not to engage into a merger or acquisition. Unfortunately, presented in Martynova and Renneboog (2008) is only an overview of these merger waves, not an indepth investigation to test if so what economic factors determine the presence of merger waves. Figlewski, Frydman and Liang (2012) researched the effect of macroeconomic factors on default risk and corporate credit ratings and their transitions. They used several economic factors in their model, such as unemployment rate, inflation, real GDP growth, 3-month T-Bill rate and S&P 500 return and volatility. They state that adding economic factors in their model strongly increased the explanatory power of the model. Furthermore they point out that the unemployment rate and inflation are strongly related to the intensity of a credit rating upgrade. A high unemployment rate and high inflation are associated with a reduction in the intensity of a credit rating upgrade. Even though corporate credit ratings and their transitions are not directly linked to abnormal returns in mergers and acquisitions, academic work such as that of Figlewski, Frdyman and Liang (2012) does indicate that macroeconomic factors can have a direct influence on companies. Flannery and Protopapadakis (2002) investigated the effect of announcements of 17 macroeconomic factors. They state that macroeconomic factors are risk factors for companies, since these factors 14

15 may influence the cash flows of many companies and simultaneously affect the discount rate of these companies. They cite Chen, Roll and Ross (1986) by saying that economic variables may act as exogenous risk factors that causes comovement in the cross-sectional returns on equity shares. Flannery and Protopapadakis (2002) state that two macroeconomic factors, inflation and money supply, are well documented factors that have a significant effect on equity returns. In their research, Flannery and protopapadakis (2002) searched for macroeconomic factors that either had an effect on equity returns or increased the volatility of the stock market. Of the 17 factors investigated, six turned out to have an impact on the level of equity returns or on the market s volatility. Balance of trade, Unemployment and the amount of housing units in the beginning of the period only had an effect on the volatility of the equity returns. The effect these factors have on the volatility of equity returns is positive for all factors. The consumer price index and producer price index only affected the level of equity returns, and the money supply affected both the level of equity returns as well as the volatility of the equity returns. They found that the relationship between CPI, PPI and money supply with equity returns is negative for all three factors. Furthermore they found that the effect of the money supply on the volatility of the equity returns is positive. Moreover, Flannery and Protopapadakis (2002) state that two measures that are regarded as popular measures of economic activity, real GNP and industrial production, do not seem to have the same effect on the level and the volatility of equity returns. They state that announcements about real GNP lead to a lower volatility of the equity returns, and that industrial production shows a similar effect, although the effect of industrial production is weaker. Yagil (1996) also came to the same conclusion as argued above following the work of Martynova and Renneboog (2008) that the fact that merger waves tend to start during periods of economic recovery and that the end of a merger wave coincides with a stock market crash points in the direction that merger waves are influenced by macroeconomic factors. He investigates mergers between 1954 and 1979 that were paid either with cash or securities. He found that the investment level and the interest rate in the economy are related to merger activity. The two macroeconomic factors have a positive effect on merger activity and the impact of the interest rate on mergers that were paid with securities is negative. Furthermore, he found that the significance level of the interest rate is higher than the significance level of the investment level. Reviewing the prior academic work in the different topics above, some results stand out. Ljungqvist, Nanda and Singh (2006) stated that managers can gain from timing the moment of IPOs when there are irrational investors present. Moreover, Baker and Wurgler (2006) created an estimate of investor sentiment in which one of the used proxies was the number of IPOs. As argued above, this is an indication that investor sentiment and the number of IPOs are not unrelated and that managers may consider this in making and timing their corporate decisions. Furthermore it has been argued in prior literature that macroeconomic factors are related to the appearance of merger waves. If managers do time their corporate decisions, one could state that investor sentiment is related to macroeconomic factors, which can also be intuitively argued by stating that one would be willing to pay more for equity shares if the economic conditions such as unemployment rate and interest rate are favorable. This research aims to determine statistically if there is a relation between macroeconomic factors and abnormal returns involved in mergers and acquisitions and if so to determine what the impact of these relationships are. Rational investors are expected to be influenced more (less) by these macroeconomic factors then irrational investors in the beginning (ending) of a merger wave due to underconfidence (overconfidence) of these irrational investors. As 15

16 stated above investors are willing to pay more for equity shares when the economy is in a favorable state. Therefore it is to be expected that factors that portray a strong economy such as low inflation, a low interest rate and a high level of investment in the economy have a positive effect on the abnormal returns. The relationship for rational investors between inflation and interest rate with abnormal returns can thus be expected to be negative, whereas the relationship between investment in the economy and abnormal returns is expected to be positive. However, this research aims to determine if there is a statistical relationship between macroeconomic factors and abnormal returns, and if so to determine the extent of these relationships. This research does not aim to provide an answer to the question whether or not these relationships are different for rational investors on one hand and irrational investors on the other hand. The academic areas of both abnormal returns involved in mergers and acquisitions as well as the effect of macroeconomic factors on the intensity of mergers and acquisitions has been well documented. However, research on a relationship between these two areas is thin. This research may support corporate executives in their understanding of the circumstances in which it is most favorable for the corporations and its shareholders to initiate corporate decisions. Furthermore, it can help investors in understanding the circumstances that determine the abnormal returns in mergers and acquisitions, which can aid them to profit from this. 3. Research question and methodology 3.1 Hypotheses formulation The aim of this paper will be to determine if macroeconomic factors have an effect on abnormal returns that accompany mergers and acquisitions. Moreover, it aims at determining if and how strong the impact of several macroeconomic factors is on the height of these abnormal returns. The main research question will therefore be as follows: What is the effect of macroeconomic factors on the level of abnormal returns that accompany acquisitions? To be able to answer this research question adequately, several hypotheses will be formulated. First step in answering the research question is to determine if the data is in line with prior research. It may be possible that the findings in this research do not correspond with prior findings, since the sample period used in this research is more recent than most periods researched in prior academic work. According to Fuller, Netter and Stegemoller (2002) an important factor that influences the abnormal returns is the method of payment. Furthermore it is stated in the discussion of the prior literature above that payment of the bidding company by stock may indicate an overvaluation of the equity shares of the bidding company, which in turn may be an indicator of higher investor sentiment. This paper evaluates if the samples used in this research are in line with the findings of Fuller, Netter and Stegemoller (2002). This may be important for the generalization of the results. For example, if samples used in this research are absolutely not in line with prior research, it may be possible that possible new results are only applicable to the sample used in this research, and not applicable to different research. The first hypotheses will therefore be: 16

17 Hypothesis 1: The abnormal return of acquiring firms is higher for firms that finance the acquisition with stock than firms that finance their acquisition with cash. Next, the abnormal returns for the acquiring firm, the target firm and the combined wealth generation will be computed. According to Bruner (2001) many papers concluded that the target firm would experience positive abnormal returns and the combined returns would also be positive. The results on abnormal returns to acquiring firms are mixed. Bruner (2001) reports both scientific papers that show positive abnormal returns to acquiring firms as well as scientific papers that show negative abnormal returns. The second hypothesis will therefore be: Hypothesis 2: Both abnormal returns to target firms as well as the combined wealth effect are positive. Hypotheses 1 and 2 make it possible to check the outcomes with prior research as discussed earlier. To be able to answer the main research question, a hypothesis about the role of macroeconomic factors in abnormal returns has to be postulated and tested. Flannery and Protopapadakis (2002) found six macroeconomic factors that have an influence on equity returns. Of these factors, two have an influence on the level of equity returns, three factors influence the return volatility and one factor has an influence on both the level of the equity returns as well as on the volatility of these returns. Only the three factors that influence the level of equity returns will be included in this research, since it is the aim to determine the effect of macroeconomic factors on the level of equity returns and not to the determine the effect on the volatility. These factors are CPI (consumer price index), PPI (producer price index) and a monetary aggregate M1. The monetary aggregate M1 consists of all currency plus demand deposits plus other checkable deposits. These factors will be included in this research to check whether or not these factors also have an influence on abnormal equity returns. Furthermore, Yagil (1996) found two factors, investment level and interest rate in the economy that are related to merger activity. As stated before, managers can take advantage of these factors by timing their corporate decisions so that the gains from these decisions are maximized. Since investment level and interest rate in the economy have an effect on merger activity, it can be assumed that these factors also have an effect on the gains that arise from mergers and acquisitions due to this timing factor. Therefore, investment level and interest rate in the economy will also be included in this research as possible macroeconomic factors that have an effect on abnormal returns. The third hypothesis will thus be: Hypothesis 3: macroeconomic factors have an effect on the abnormal equity returns involved in mergers and acquisitions The effect of the macroeconomic factors on equity returns and merger activity is mixed in prior research. That is, some macroeconomic factors portrayed a positive effect, whereas other factors portrayed a negative influence. It is therefore expected that the effect on abnormal returns will also be mixed. 17