The impact of underlying strategic motives of M&A on shareholder wealth

Transcription

1 Aarhus University Business and Social Science August 2014 The impact of underlying strategic motives of M&A on shareholder wealth Evidence from the global financial industry Author: Advisor: Lisa Isabella Kralle MSc Finance & International Business PhD Jan Bartholdy, Associate Professor Department of Economics and Business

2 Abstract This event study analyzes the impact of the underlying strategic motives of mergers and acquisitions (M&A) on target and acquirer shareholders wealth around the day of the deal announcement. The analysis is based on two samples of respectively 86 and 143 deal announcements in the global financial industry over the period from 1997 to The cumulative abnormal return (CAR), calculated as the difference of actual return and the expected normal return in a five-day event window, is used to measure the impact. Mostly, no statistical significant influence was found on the abnormal return to either target or acquiring shareholders due to a deal s motivation. The evidence presented challenges previous empirical findings. The payment method chosen was found to have no significant statistical impact on target shareholders wealth. However, the CAR to bidder stockholders is positively influenced. While target shareholders receive abnormal return when a deal is domestic, no reaction was found when analyzing the acquiring companies sample. Harmonized regulatory and supervisory environment within the European Union (EU) is found to have a negative impact on target shareholders wealth while acquiring shareholders neither penalize nor reward for a deal being within the EU. When relatively small firms are acquired, M&A deal announcements create higher benefits to bidder shareholders. KEYWORDS: Event study; mergers and acquisitions; financial industry

3 I Table of content I. Introduction... 1 I.A Motivation & problem statement... 2 I.B Scope and Delimitation... 3 I.C Evaluation of sources... 3 II. Theory and literature review... 4 II.A Review of relevant theory... 4 II.A.i Neoclassical theory... 4 II.A.ii Behavioral theory... 5 II.B Review of relevant empirical evidence... 6 II.B.i Underlying strategic motive... 7 II.B.ii Payment Method... 8 II.B.iii Cross-border versus domestic M&A II.B.iv Regulatory environment II.B.v Relative size III. Methodology III.A Efficient market hypothesis III.B Estimation period, event day & event window III.C Abnormal Return calculation & models III.D Parametric and non-parametric tests III.D.i Parametric tests III.D.ii Non-parametric tests III.E F-Test III.F Cross sectional regression... 22

4 II IV. Data IV.A Data Selection Process IV.B Descriptive Statistics IV.B.i Target Sample IV.B.ii Acquirer Sample V. Empirical Evidence V.A Test statistics V.A.i Target sample V.A.ii Acquirer sample V.B F-Test V.C Cross-sectional regression V.C.i Target V.C.ii Acquirer VI. Limitations and suggestions for further research VII. Conclusion References Appendix... 53

5 List of figures III FIGURE 1: EVENT STUDY TIMELINE FIGURE 2: EU VERSUS NON-EU, TARGET SAMPLE FIGURE 3: EU VERSUS NON-EU, ACQUIRER SAMPLE FIGURE 4: NUMBER OF DEALS OVER TIME, TARGET SAMPLE FIGURE 5: NUMBER OF DEALS OVER TIME, ACQUIRER SAMPLE FIGURE 6: DEVELOPMENT STRATEGIC MOTIVE OVER TIME, TARGET SAMPLE FIGURE 7: DEVELOPMENT STRATEGIC MOTIVE OVER TIME, ACQUIRER SAMPLE List of tables TABLE 1: COMPOSITION OF TARGET SAMPLE TABLE 2: DESCRIPTIVE STATISTICS TARGET SAMPLE TABLE 3: COMPOSITION OF ACQUIRER SAMPLE TABLE 4: DESCRIPTIVE STATISTICS ACQUIRER SAMPLE TABLE 5: RESULTS T-TESTS TARGET, SUBSAMPLE MARKET GROWTH TABLE 6: RESULTS T-TESTS TARGET, SUBSAMPLE SYNERGY EFFECTS TABLE 7: RESULTS T-TESTS TARGET, SUBSAMPLE DIVERSIFICATION TABLE 8: RESULTS T-TESTS ACQUIRER, SUBSAMPLE MARKET GROWTH TABLE 9: RESULTS T-TESTS ACQUIRER, SUBSAMPLE SYNERGY EFFECTS TABLE 10: RESULTS T-TESTS ACQUIRER, SUBSAMPLE DIVERSIFICATION TABLE 11: RESULTS F-TEST, TARGET & ACQUIRER SUBSAMPLES TABLE 12: CROSS-SECTIONAL REGRESSION TARGET SAMPLE (I) TABLE 13: CROSS-SECTIONAL REGRESSION TARGET SAMPLE (II) TABLE 14: CROSS-SECTIONAL REGRESSION ACQUIRER SAMPLE (I) TABLE 15: CROSS-SECTIONAL REGRESSION TARGET SAMPLE (III) TABLE 16: CROSS-SECTIONAL REGRESSION ACQUIRER SAMPLE (II) TABLE 17: CROSS-SECTIONAL REGRESSION ACQUIRER SAMPLE (III)... 86

6 IV List of abbreviations AMEX - American Stock Exchange BMP - Boehmer, Musumeci, and Poulsen CAR - Cumulative abnormal return CSE - Copenhagen Stock Exchange DV - Deal value EMH - Efficient market hypothesis EU - European Union M&A - Mergers and Acquisitions MV - Market value NASDAQ - National Association of Securities Dealers Automated Quotations OLS - Ordinary least square Sig. - Significant TSX - Toronto Stock Exchange US - United States

7 1 I. Introduction Mergers and acquisitions (M&A) refer to the consolidation of companies where a change in control takes place through a transfer of ownership and a new company is formed (Group of Ten 2001). Such investment decisions play an important role in the economic development in the last century up until today. M&A was primarily traced in the United States (US), and is nowadays seen throughout the world (Andrade et al. 2001). However, a majority of deals are still concentrated in the US (Amel et al. 2004). Extensive empirical research has been conducted over the years with the intention of providing an explanation on what drives M&A, the deals impact on shareholders wealth and different deal characteristics. M&A activity was particularly distinct in the financial industry (Amel et al. 2004). It experiences consolidation since the 1980s and the number of deals has risen steadily ever since leading to changes in the industry s structure. While from 1990 to 1995, the total number of M&A in the main industrial countries 1 in the financial industry 2 was 4,369; it increased to a total of 6,035 deals in the years from 1996 to 2001 (compare appendix 2). As a result, the total number of financial firms decreased significantly and the remaining companies are greater in size, more diversified and often operate worldwide (DeYoung et al. 2009). There is general agreement that M&A is a reaction to changes in the firms environment. Among others, financial and technological progress led to an increase in consolidation (Amel et al. 2004). Technological innovations for example in deposit taking and lending, and payment systems changed the banking infrastructure (Humphrey et al. 2006), as well as innovations in the methods and techniques of financial engineering (Group of Ten 2001). Further, more sophisticated products (for example credit default swaps) and markets (for example derivative market) changed the financial landscape and the requirements for financial institutions. Additionally, financial deregulations and decreasing restrictions enable corporations to fully benefit from these innovations (Berger et al. 1999) and expand in markets or sectors that were previously restricted (DeYoung et al. 2009). 1 G10 countries, as well as Australia and Spain 2 Banks, insurance companies and other financial firms

8 2 Although the countries financial industries differ greatly in terms of structure, regulations, and development from country to country (Barth et al. 2004), the underlying strategic motives of M&A are common. Financial corporations intend to create synergy effects and thus, enhance their efficiency. Further, firms aim to increase their market share and attract new customers and thereby, increase their profits. Moreover, the diversification of the product range offered is a common reason for takeover in the financial industry (Amel et al. 2004). I.A Motivation & problem statement A lot of research has been conducted on the effect of M&A on target and acquirer shareholders wealth, yet little focus was put on the question whether the underlying strategic motive has an impact on short-term wealth. This study s ambition is thus to analyze this specific deal s characteristic. Moreover, this analysis represents an extension to the already existing empirical evidence, which focuses mainly on the US, as a global perspective will be adopted. Therefore, past literature on M&A s motivation will be reviewed in combination with a quantitative analysis will be done to examine the cumulative abnormal return on the days surrounding the deal announcement. Precisely, the following research question will be investigated: Does, in the financial sector, the underlying strategic motive of a M&A deal announcement have an impact on shareholders wealth of acquiring and target company, respectively? In order to gain a deeper understanding and provide a profound analysis, the following sub-questions will be answered in connection with the main research question: (1) What impact does the payment method have on the cumulative abnormal return (CAR) to shareholders of the target and acquiring firm? (2) What impact does it have whether the deal is domestic versus cross-border on the CAR to shareholders of the target and acquiring firm? (3) What impact do differing regulations have on the CAR to shareholders of the target and acquiring firm? (4) What impact does the relative size have on the CAR to shareholders of the target and acquiring firm?

9 3 In order to answer the questions above, it will be tested whether the return to shareholders of target and acquiring firms is significantly higher than the market return. To this end, the event study approach will be used. The paper is structured as followed: In the section following the introductory part, relevant theory and literature on the different motives of M&A will be reviewed. Moreover, empirical findings on M&A will be summarized and serve as base for the formulation of the hypotheses. In section three, the event study methodology, the test statistics being used and the cross-sectional regression will be described. Section four reviews the data selection process. Further, the final sample and its descriptive statistic will be presented. In section five, empirical findings will be analyzed. Implications and validity of the different test statistics and the cross-sectional regression will be presented. In section six, the limitations of this study will be explained and suggestions for further research will be made. Finally, section seven contains a conclusion. I.B Scope and Delimitation Due to the scope of this study, delimitation was made. First, in this study, only the short-term wealth effect of the announcement of a takeover is assessed based on the assumption that markets are efficient. The efficient market hypothesis will be discussed in section III.A. Long-term performance, however, will not be analyzed. Second, a detailed explanation of all statistical tests will not be given. However, an overview of all tests performed will be presented in section III.D and formulas and calculation can be found in the appendix 1 and 6. Instead, its application and interpretation will be emphasized. In terms of data selection, this study focuses on the financial sector solely and thus, all M&A deal announcements from non-financial sectors are eliminated. Further, only listed companies are included in the study. A detailed explanation of the data selection criteria can be found in section IV.A. I.C Evaluation of sources The majority of sources used are academic journal articles. Only well ranked journals were read, evaluated and cited. This choice has been made in order to ensure a high quality of references. Before an article is published in such a journal, it must go through a peer review process and it can, thus, be ensured that the content is sound and has academic value. Prior event studies on similar research questions represent a considerable part of the literature reviewed. Thereby, different perspectives and

10 4 opinions could be taken into account and compared. It is aimed to use a great variety of different sources in this study in order to provide a vital discussion and profound understanding. II. Theory and literature review This section is divided into two main parts. First, the relevant theory will be reviewed. The theory with respect to motives underlying M&A can generally be divided into two clusters: the neoclassical and the behavioral theory. A good understanding of the main differences is crucial in order to discuss the wealth effect of takeovers on bidders and targets shareholders. Second, empirical evidence on different firm and deal characteristics will be presented, which will serve as base for the development of the hypotheses. II.A Review of relevant theory II.A.i Neoclassical theory The neoclassical explanation on why two firms merge is based on the idea that M&A is a reaction to changes in the firms regulatory, technological, or economic environment (Harford 2005; Mitchell & Mulherin 1996). M&A is hence seen as a rational response to changes in the industry (Amel et al. 2004). Managers, being rational, need to react to these changes in order to maintain or improve the firm s performance. The management continuously wishes to maximize the value of the firm and increase shareholders wealth (Sudarsanam et al. 1996). Therefore, firms only enter into a M&A deal if the expected return is positive for both, target and acquiring shareholders. This happens if synergy effects are created (Berkovitch & Narayanan 1993). Generally, synergy effects can be derived from three different sources; namely operational, managerial, and financial synergies. Operational synergies can be created either by revenue enhancement or cost reduction. The former mostly results from new opportunities due to the merger of two or more companies (Gaughan 2011). Cost reduction can be created mostly from economies of scale and scope (Porter 1985) and its exploitation is seen as a main source for value creation that stem from M&A (Amel et al. 2004; Asimakopoulos & Athanasoglou 2013). Companies with similarities in activities, products, or industries usually profit the most from economies of scale and

11 5 scope (Sudarsanam et al. 1996). Further, horizontally or vertically related firms may increase their power within a common industry by undertaking M&A (Sudarsanam et al. 1996). Managerial synergies, in turn, may be realized if the bidder s management is more competent and possesses a better skills and ability set in comparison to the target s management (Trautwein 1990). The target s managers are, thus, subject to disciplinary actions. Generally, such takeovers are expected to create value for both, acquiring and target company (Sudarsanam et al. 1996). There are three different sources for financial synergies. First, the combined firm may profit from tax advantages. These can be realized when bidder and target vary in their gearing. If one firm has unused debt capacity whereas the other has excessive leverage, synergies can be exploited the most (Sudarsanam et al. 1996). Second, according to Myers & Majluf (1984), when there is a mismatch between a company s resources and investment opportunities, a merger can correct for it if the firms mismatches are complementary. Consequently, synergies can be realized. Last, financial synergies can be achieved when the cash flows of the joining firms are not perfectly correlated. The merger of these firms would thus lead to a reduction in default risk (co-insurance effect). This idea was first proposed by Lewellen (1971) where he, however, solely analyzed the effect on shareholders wealth. Higgins & Schall (1975) and Galai & Masulis (1976) extended his analysis and concluded that not only the company s creditors would benefit from the merger, but also the market value of the already outstanding debt would increase. II.A.ii Behavioral theory Within the behavioral framework, there are two categories of motives on why firms merge: the agency and hubris motive. The agency motive suggests that managers are rational. However, they do not always act in the interest of the shareholders. The bidder s management is mainly concerned with its own welfare and chooses the target that creates the highest value for them (Berkovitch & Narayanan 1993). Generally, this can be viewed as an agency problem, where the interests and objectives of the shareholders (principle) and managers (agents) differ. This problem is associated with the separation of management and ownership of a company (Jensen & Meckling 1976; Shleifer & Vishny 1997). Further, Jensen (1987) explains for example that the management does often not give up projects they have already been working on for several years even though they do not create any value to the firm. Additionally, he argues that managers tend to invest free cash flows in M&A that do not create value.

12 6 These free cash flows should rather be paid out to the stockholders but this way; the managers power would be reduced. This phenomenon is often referred to as empire building: The management intends to increase its influence and reputation by increasing a firm s size (Jensen 1987; Trautwein 1990). In the scenarios stated above, the target will as well attempt to benefit from the deal. Depending on its bargaining power, it will succeed in doing so. If the target is aware of its own value to the acquiring company s management, it will try to obtain some of the value that is created (Berkovitch & Narayanan 1993). The hubris motive suggests that managers behave irrational and make mistakes when evaluating the target company. Consequently, deals are often overpaid. According to Roll (1986), the acquirers management is too self-confident and by overestimating the takeover s gains, they pay too much for their targets. The managers believe that the market does not fully reflect all information available and the value of the merged firm is considerably higher than what the market expects. In contrast to the agency hypothesis, the management does not consciously behave in a way that does not maximize the shareholders wealth. The management does however, believe that their actions are in line with shareholders interest but they overestimate their abilities in correctly valuing a merger s gain (Malmendier & Tate 2008). Roll (1986) further argues that managers being infected by hubris can be explained among others by the winner s curse. Capen et al. (1971) first discussed the idea that in competitive bid situations, the bidder who is the most over-confident usually wins the bid. Thus, managers are willing to pay high premiums above the market price. Berkovitch & Narayanan (1993) support Roll's (1986) ideas and find strong evidence supporting the hubris hypothesis. Likewise, Malmendier & Tate (2005; 2008) empirically tested and confirmed the overconfidence hypothesis. Moeller et al. (2004) found that especially managers of large firms tend to suffer from hubris and are, thus, more likely to overpay for a target. They further present evidence that the level of premium offered is linked to a firm s size: the larger the firm the higher the premium. II.B Review of relevant empirical evidence In this section, a variety of deal- and firm-specific characteristics will be addressed and based on the empirical evidence presented nine hypotheses will be formulated. After

13 7 reviewing the relevant theory on underlying motives for takeovers, empirical findings on this subject with focus on the financial industry will be presented. Further, the impact of the choice of payment method and differing regulation on shareholders wealth will be assessed. Additionally, cross-border and domestic deals will be compared and lastly, it will be analyzed whether the ratio of deal size and acquirers market value (relative size) has an impact on the abnormal return. II.B.i Underlying strategic motive A lot of research has been conducted on the effect of M&A on shareholders wealth. Most of the empirical research focuses on the US market; while evidence on the European market is fairly scarce (Asimakopoulos & Athanasoglou 2013). Generally, it is found that deal announcements have a positive impact on targets shareholders wealth whereas the results on acquiring financial firms are inconclusive. It is often argued that wealth shifts from the acquiring shareholders to those of the target (Houston & Ryngaert 1994). Among others, Campa & Hernando (2006) provide evidence in their study on the European financial industry that gains of target shareholders due to M&A are positive around the date of the deal announcement. James & Wier (1987) and Bertin et al. (1989) find in event studies on acquiring banks low but positive abnormal returns, while Houston & Ryngaert (1994) find negative abnormal returns. All studies were conducted on the American stock exchange (AMEX) based on daily data. Although the studies on acquiring companies mentioned do not exclusively focus on the financial industry, their results are still valid for this study since the wealth effect of M&A within the financial and non-financial sector are similar as stated by Amel et al. (2004). Rather few studies focus on an analysis of the impact of the underlying strategic motive of M&A, particularly limited is the literature on the financial industry. Berkovitch & Narayanan (1993) categorize in their study on 330 tender offers on the New York Stock Exchange (NYSE) and the AMEX, all deals in either of the following three motives: synergy, agency, and hubris. They provide evidence that when an M&A is based on the synergy or hubris motive, the target shareholders gain significant positive returns whereas they record a decrease in wealth when the motive is agency. When looking at studies conducted on banking M&A, Houston & Ryngaert (1994) argue that shareholders react positively when they see the opportunity of cost savings due to a takeover. Further, Zhang (1995) provides evidence that there is an increase in wealth

14 8 due to M&A when geographic diversification or increase in efficiency is intended. Cornett et al. (2003) and DeLong (2001) compare diversifying and focusing bank acquisitions, where diversification is measured in two dimensions: geography and activity. In both studies, focusing acquisition perform better than diversifying M&A. Cornett et al. (2003) show that focusing M&A earn zero abnormal return for acquirer while diversifying both, geographically and activity wise, lead to negative abnormal return. Cornett et al. (2003) support this evidence. DeLong (2001) analyze the combined value effect and find that a focus strategy leads to a wealth increase. Based on the empirical evidence reviewed, it can be concluded, that the underlying strategic motive of M&A does have an impact on shareholders wealth and, thus, the following hypotheses are formulated. H 1A : H 1B : Different underlying strategic motives of M&A have an impact on the CAR for target. Different underlying strategic motives of M&A have an impact on the CAR for acquirer. II.B.ii Payment Method Generally, there are three different payment methods of a M&A deal. The bidding firm either pays in cash (cash is paid in exchange for target shares), equity (based on a defined ratio, a certain number of the acquirer s shares are exchanged for one target share), or a combination (share and equity, converted debt, or deferred payment). The choice of financing is important for various reasons. Different theories can be found in the literature. Stulz (1988) conducted an analysis focusing on the influence of corporate control on a deal s payment decision. Harris & Raviv (1988) propose a similar theory. According to both papers, the management aims to maintain its power and influence and this, in turn, has a large impact on an M&A financing decision. Managers rather finance takeovers using cash or debt than by issuing new shares because they do not want their stock holdings to be diluted. Amihud et al. (1990) tested their hypotheses empirically and support the existence of a relation between the choice of payment mean and a firm s ownership structure. Travlos (1987) argues that if the management believes that their company is overvalued, they choose to pay in stock while if they suppose it is undervalued, they will offer cash. Myers & Majluf (1984) present the same idea. They

15 9 assume that the management acts in the interest of the company s shareholders. Consequently, the market sees a cash offer as a positive signal, whereas stock offers are interpreted as bad news (signaling hypothesis). Fishman (1989) presents a different approach based on the assumptions of asymmetric information 3 and the threat of competitive bidding 4. In his model, the target only accepts offers that are equal or higher than its private valuation. If there is more than one bid, the target accepts the highest offer. Additionally, a target is more likely to accept a cash offer since, different from a stock offer, the acquisition price is constant. Further, he argues that a cash offer signals a high valuation of the target and preempts other firms from bidding. Generally, the risk of a competitive bid is lower when a deal is paid with cash not only because of the signaling effect but also because a deal can be completed faster when paid with cash. This is partly because of regulative burdens when the exchange of stock is chosen (Wansley et al. 1983). Hansen (1987) has a similar approach. He, however, includes the contingency pricing effect of stock in his model: When a deal is financed with stock, both, target and acquirer shareholder bear the risk that the bidder may have overpaid. Finally, the choice of payment method does as well have tax implications, which need to be considered. When the mean of payment is stock, an M&A is generally tax-free for the target stockholder. Possible capital gain tax must be paid at a later point in time once a shareholder decides to sell its stock holdings. However, cash acquisitions create an immediate tax obligation for the target shareholders. Consequently, the acquirer will have to compensate for the tax burden and, thus, the acquisition price increases ( Travlos 1987; Wansley et al. 1983). All ideas mentioned are tested empirically. Travlos (1987) presents evidence for 60 companies that there is a significant difference in the effect on the abnormal return of the acquiring firm due to the choice of payment method. He concludes that shareholders of bidders loose if the acquiring company chooses to pay with stock and thus, the CAR decreases. In contrast, when a deal is completed with a cash payment the shareholders CAR increases. He further concludes that these results are independent from the type of 3 Both, target and acquirer have solely information about their own value not about the other party s value 4 There is more than one bidder in the market.

16 10 takeover. Brown & Ryngaert (1991) and Andrade et al. (2001) support his findings. They confirm that the use of a stock offer when acquiring a firm has a negative impact on the abnormal return, whereas cash offers have a positive impact on the excess return. Wansley et al. (1983) found in their study on 203 M&A deals that target firms report an increase in CAR of percent when the means of payment is cash, whereas shareholders earn approximately half (on average percent) when a deal is paid with stock. To conclude, there is a general agreement among researchers and based on the evidence stated above, the following hypotheses are formulated: H 2A : H 2B : CAR to target shareholders is significantly higher when the payment method chosen is cash than it is for equity or mixed payments. CAR to acquirer shareholders is significantly higher when the payment method chosen is cash than it is for equity or mixed payments. II.B.iii Cross-border versus domestic M&A M&A activity can be divided into two groups: domestic deals and cross-border transactions. Not a lot of research has been done on this particular topic for the financial industry (Bos & Schmiedel 2007). Thus, most studies are conducted by performing simulations (Amel et al. 2004). In the 90s, the majority of M&A in the financial sector were domestic, and only a small proportion of transactions were cross-border of which most were insurance related (Abraham & Dijcke 2002). At that time, European banks for example generated most of their revenue in their home market (Abraham & Dijcke 2002). However, deregulations and integration of national markets, as well as the increasing competition, led to a surge in cross-border M&A transactions (Díaz Díaz et al. 2002; Focarelli & Pozzolo 2001). Though, cross-border mergers in the financial industry still occur less frequently than in non-financial sectors (Berger et al. 1999). Domestic and cross-border deals differ in their motivation. Abraham & Dijcke (2002) present an overview of the main motives of banking mergers. At this point, it is important to mention that M&A within the financial industry have similar patterns

17 11 (Focarelli & Pozzolo 2008). Cost saving and the realization of economies of scale are the main reasons for domestic M&A, whereas cross-border deals are driven by a firm s desire to grow further (Abraham & Dijcke 2002; Focarelli & Pozzolo 2008). When a firm outgrows its home market, it often intends to expand to foreign markets. Generally, another driving force for cross-border M&A are market imperfections. Hymer (1976) argued that financial firms can profit from the exploitation of these as much as firms from other sectors. The greater a corporation s ability to use market differences to their own advantage, the higher the benefits due to its cross-border expansion (Miller & Parkhe 1998). Gray & Gray (1981) found that the regulatory environment and market restrictions in the US restraint banks and the market is thus, seen as imperfect. Therefore, financial corporations are encouraged to expand cross-border in order to remain profitable or enhance their revenues. Moreover, companies within the financial sector can better diversify their risk when merging with or acquiring firms outside their home country. This is due to the assumption that capital markets of different countries are not perfectly correlated (Miller & Parkhe 1998). Allen N. Berger et al. (2001), for example, find a low correlation between bank revenues of Japan, the US and the EU. Thus, financial firms can reduce their risk exposure (e.g. insolvency risk) by doing M&A (Amihud et al. 2002; Díaz Díaz et al. 2002). Another important theory to look at is Dunning s (1977) eclectic paradigm. This internationalization theory is based on the assumption that a company rather makes transactions internally than on an open market as long as internal transaction costs are lower. According to Dunning, there are three different factors to consider when deciding whether to pursue an internationalization strategy. Namely, a company has to have internationalization, ownership, and locational advantages 5. Yannopoulos (1983) linked the eclectic paradigm to the banking industry. He finds that banks have all three categories of advantages named above available. Nevertheless, cross-border transactions present particular challenges to the parties involved. Besides language and cultural difficulties, differences in market conditions 5 Internationalization advantage: it is most profitable for firms to exploit opportunity abroad itself (rather than through a partnership or joint venture); ownership advantage: the firm possesses a competitive advantage; locational advantages: the benefit of cross-border business must be greater than with only domestic establishment

18 12 and policies require a lot of resources (Allen N Berger et al. 2001; Amel et al. 2004). Especially within the financial sector, corporations face regulatory barriers and governmental restrictions (Díaz Díaz et al. 2002). Often, local governments support national companies and disapprove M&A by foreign companies (Boot 1999). Further, companies can be discouraged to expand abroad because domestic firms operate more efficient in their own country, which is referred to as home field advantage hypothesis. Operating and monitoring business in a foreign country from the distance is comparably difficult and costly (Allen N. Berger et al. 2001). The majority of literature suggests that domestic M&A have a positive impact on the abnormal return whereas cross-border deals have no or a negative impact. In their study on European M&A, Beitel & Schiereck (2001) provide evidence that acquirers and targets combined value of domestic deals are positive. However, combined value does not increase from cross-border transactions. Cybo-Ottone & Murgia (2000) support these findings in their study on the European financial sector. They find that gains to shareholders are significantly positive from domestic banks while cross-border deals lead to negative abnormal returns. DeLong s (2001) evidence contradicts these results. Studying M&A of US banks, he found that cross-border consolidation creates value. This however, is one of very little studies providing evidence on significant gains arising due to cross-border deals (Amel et al. 2004). Shifting our focus to the gains to target shareholders explicitly, Campa & Hernando (2006) find that abnormal returns to target shareholders are significantly lower in crossborder transactions in comparison to domestic M&A. Campa & Hernando (2002) provided similar results. Thus, the following hypotheses can be derived: H 3A : H 3B : CAR to target shareholders is significantly higher when a domestic M&A is announced than for cross-border M&A announcements. CAR to acquirer shareholders is significantly higher when a domestic M&A is announced than for cross-border M&A announcements.

19 13 II.B.iv Regulatory environment Unfortunately, information on the regulatory environment in different countries is very limited (Barth et al. 1999) and hence, a comparison is difficult. Therefore, in this section, the focus is on the regulatory environment in the European financial sector and its particularities. A general overview of financial industry regulations will be given and further, the development of the regulatory environment within the EU will be described. It will be argued that the gradual removal of regulatory barriers should facilitate M&A transactions within the EU. Generally, the financial sector is one of the most tightly regulated industries (Buch 2000). Vives (1991) provides a general overview on these regulations. When looking at regulations of the financial sector, one can distinguish between bank and non-bank financial services. The purpose of bank regulations is the maintenance of stability and protection of the banking system from negative shocks. In particular, small investors are subject of protection. Non-bank regulations rather focus on reducing information asymmetries between investors on one side and portfolio managers, advisors or brokers on the other. There are two types of regulations, namely structure and conduct regulations. Part of the structure regulations is for example the Glass-Steagall Act from 1933, that is separation of commercial and investment banking in the US, or the Basel Accords, a framework including minimum capital requirements. Conduct regulations are for example concerned with information disclosure or pricing rules. The European financial industry is shaped by a variety of regulatory reforms, which were implemented in the course of the years (Bos & Schmiedel 2007). Since the 1970s, legal reforms were put in place to facilitate cross-border operation within the EU. The First Banking Co-ordination Directive (1977) forms a first base for the elimination of legal obstacles within the EU; among others, freedom of establishment was allowed (Buch 2000). This was followed by the implementation of the Second Banking Coordination Directive in It includes the introduction of a single banking license valid throughout Europe, as well as the base for the harmonization of unified capital requirements for example. In 1993/1994, universal banking was set as the standard system. In the subsequent years, additional EU directives were signed with the intention to create a unified European security market and further eliminate regulatory barriers.

20 14 With the creation of the European Monetary Union, currency conversion costs were minimized (Allen N Berger et al. 2001). Thus, the European financial market is well integrated. There is a minimum of legal obstacles and financial sector s regulations are harmonized throughout the different countries of the EU. Expansion through M&A is not restricted and financial institutions are allowed to operate within the EU (Vives 1991). Berger et al. (2003) provide evidence that corporations prefer to expand to countries where the legal and regulatory barriers are low. Further, corporations are familiar with the regulatory environment. These factors make M&A relatively easy, more rapid and less capital-intensive (Allen N Berger et al. 2001). Consequently, it can be argued that the harmonization of the regulatory and supervisory environment within the EU leads to more successful M&A. Empirical evidence or event studies on this subject are rarely found in literature. However, based on the argumentation above, the following hypotheses are formulated: H 4A : H 4B : CAR to target shareholders is significantly higher in M&A transactions within the European Union. CAR to acquirer shareholders is significantly higher in M&A transactions within the European Union. II.B.v Relative size In literature, it is agreed that when a rather small firm is acquired, the takeover is less complex and it is, hence, easier to create value (Campa & Hernando 2005). Hawawini & Swary (1990) also find that when buying a target firm, which is relatively small, the potential to increase efficiency is higher. Further, Kuehn (1975) argues that integrating a small target requires less effort and might be cheaper for the acquiring company. However, the creation of scale effects and the possibility of gains from synergies might be smaller (Beitel et al. 2004). There are various ways of measuring the relative size of target and acquirer. This study will focus on the impact on the relative size on the acquirers CAR. Thus, in line with

21 15 Walker (2000), relative size in this study is measured by dividing the deal value by the acquirer s market value three month prior to the acquisition (DV/MV). Another very common method is to divide the target s market value by the acquirer s market value (Zhang 1995; Houston & Ryngaert 1994) at a given point in time. Gupta & Misra (2007) analyzed in their event study on 503 merger bids between US banks, among others the effect of relative size on the three-day abnormal return. Regressions on the full sample do not show significant results for the coefficient relative size. However, in a study on 123 US banking M&A, Hawawini and Swary (1990) found that deals where the target s relative size to the bidder is small, acquirers gains are higher. Zollo & Leshchinkskii (2000) support these findings in their study. Zollo et al. (2013) as well as Houston & Ryngaert (1994) provide evidence that reduced relative size leads to higher returns on average for both, acquirer and target. Therefore, the following hypothesis is posited: H 5A : CAR to acquirer shareholders is significantly higher in M&A where the relative size is comparably small. In order to test the hypotheses mentioned above, the approach of an event study is used. In the following, the methodology will be explained in detail. III. Methodology Generally, event studies are used to examine the effect of a firm-specific unanticipated event such as stock splits, earning announcements, or dividend payments on a company s value. Looking at financial market data, more precisely stock prices, the impact of such an event can be measured (MacKinlay 1997). While the variety of events to be analyzed is great, the elements of an event study are always the same. Peterson (1989) and Campbell et al. (1996) describe the exact procedure of an event study. First, an event needs to be specified and identified. Second, a sample has to be determined. All companies, which are included in the study, are required to fulfill well-defined criteria. This is followed by the definition of the estimation period and the event window. Fourth, the abnormal return - often referred to as excess return - is calculated. It is the difference between the observed return and the predicted normal return in the

22 16 event window. Fifth, it is tested whether the abnormal return is significant, that is statistically different from zero (McWilliams & Siegel 1997). However, the use of the event study approach is solely appropriate when markets are assumed to be efficient (McWilliams & Siegel 1997). The market efficiency hypothesis is, thus, briefly explained in the following. III.A Efficient market hypothesis In an efficient market, a company s share price fully reflects all currently available information. Once unanticipated financially relevant information is revealed, prices adjust instantaneously because any investor being aware that a stock is undervalued would buy it immediately leading to an increase in price up until its fair value (Fama 1965; Fama 1970;). Thus, no arbitrage opportunities exist and no investor is able to outperform the market in the long run (Fama 1970; Jensen 1978). Roberts (1967) first suggested the distinction between weak and strong efficiency. Followed by Fama (1970), who, in his first definitive paper on the efficient market hypothesis (EMH), presents three forms of efficiency differing in their subset of information: the weak, the semi-strong, and the strong form of efficiency. The weak form of the EMH asserts that any stock price at a given point in time reflects all past information. Thus, the best predictor of future stock performance is the current share price. As stock movements follow a random walk a better prediction through analysis is not possible (Samuelson 1965). The semi-strong form of the EMH is concerned with the speed in which stock prices adjust to publicly available information. Fama (1970) and Ball (1978) suggest that all relevant information to the market such as stock splits, future dividend payments, or earning announcement is incorporated in the stock price. Hence, fundamental analysis would be irrelevant (Malkiel 2003). Fama (1991) refers to this version of efficiency in a later paper as event study. The strong, the most extreme form of efficiency, states that not only public but also private information is reflected in a firm s stock price. Consequently, it is impossible to anyone to earn excess return on the stock market. This form of efficiency rather constitutes a model than representing the reality (Fama 1970). Especially in the 1980s and 1990s, numerous researchers rejected the validity of the EMH. LeRoy & Porter (1981) and Shiller (1981) challenged the EMH for example by showing excess volatility in the stock market. However, a lot of research has been

23 17 conducted supporting the EMH, particularly the semi-strong efficiency. Ball (1978) and Jensen (1978) strongly support the EMH. According to both scholars, market efficiency and its validity have been tested empirically. In particular, when looking at stock market reactions to publicly available information, the EMH has been proved. Fama (1991) claims that event studies provide the most direct and best evidence on the EMH. III.B Estimation period, event day & event window The event day is set as the day of the announcement of a M&A deal, defined as t = 0. Let t = T 1 to t = T 2 be denoted as the event window while t = T 0 to t = T 1 constitutes the estimation period. The timeline for the event study looks thus, as followed: Figure 1: Event Study timeline Estimation period Event window T 0 T 1 0 T 2 t Identifying and determining the event day correctly is crucial. Misspecification might lead to incorrect results of the event study. The event has to be firm-specific and its occurrence must affect the stock price (Corrado 2011). In line with Cybo-Ottone & Murgia (2000) and Zhang (1995), in this study, the official announcement of an M&A deal was chosen. In a perfectly efficient market, the event window would be restricted to one day. However, in practice, it is extended to three to five days. Following Peterson s (1989) approach, the event window is set with a length of five days, including two days prior and two days after the event in order to make sure that the entire effect is captured. There are three reasons for the choice of this extended event window. First, the date of the announcement might not be the same as the date when the market actually gets the information (Peterson 1989). Further, it is proven that the reaction time on European stock markets is longer. As the sample contains a rather extensive number of European deals, the choice of a five days event window is deemed to be appropriate. Last, rumor

24 18 and announcement date of the acquisition are allowed to lie apart a maximum of two days. The estimation period is set with a length of 240 days. This corresponds to a trading year. Peterson (1989) and Bartholdy et al. (2007) argue that an estimation period of 100 to 300 or 200 to 250 days respectively is sufficient when conducting an event study based on daily returns. Using stock data of 240 subsequent days, the parameters needed to calculate the normal return can be estimated satisfactorily. Consistent with MacKinlay (1997), the event window and the estimation period do not overlap in order to avoid any influence. III.C Abnormal Return calculation & models There is a variety of statistical models available when measuring the normal return that would be expected if there would not have been an announcement of a M&A deal. Peterson (1989) and Brown & Warner (1980) discuss three models: the risk-adjusted model, the mean-adjusted model, and the market-adjusted model. Another option are multi-factor models (compare Dyckman et al or Fama & French 1993). A detailed explanation of all models would go beyond the scope of this paper. Thus, it will focus on an explanation of the market-adjusted model and its advantages. This model is chosen to be used because it encompasses the other two models and it is less restricted (Peterson 1989). Both, mean-adjusted and risk-adjusted model are simpler and, therefore, easier to use. However, when using the market-adjusted model, the returns of a firm s stock and the market portfolio are related and consequently, the part of the return that is related to the variance in the market return is eliminated (MacKinlay 1997). The abnormal return for each stock j at a given day t is defined as the difference between the actual return and the expected return. According to the market model the expected return is calculated as followed: E(r jt ) = α j + β j r mt + ε jt, t = 242,, 3 (1) where r jt is the actual return of stock j on day t. r mt is the return of the benchmark index

25 19 on day t, in this case the official Datastream country index for the financial industry. As this event study looks at M&A deals in a variety of countries focusing on the financial industry this index was chosen. A detailed explanation of the index is provided on the CD in appendix 1. The coefficient α j (intercept) and β j (systematic risk) are firmspecific parameters, which are estimated using the ordinary least square (OLS) method. ε is the residual of the model. The abnormal return is then calculated as stated in equation (2) and (3). A jt = r jt E(r jt ) (2) A jt = r jt (α j + β j r mt + ε jt ), t = 2,,+2 (3) In order to capture all effect, the abnormal returns in the event window of a given stock j are summed up, resulting in the cumulative abnormal return (CAR). CAR j = A j,-2 + A j,-1 + A j,0 + A j,+1 + A j,+2 (4) All calculations are provided on the CD in appendix 1. III.D Parametric and non-parametric tests A battery of test statistics will be performed based on the previously calculated CAR. Bartholdy et al. (2007) recommend to not only perform one single test, as different results can be obtained with different test statistics. It is important to stress the fact that no individual test is superior to another. In line with Brown & Warner (1985), the null hypothesis to test is whether the CAR is equal to zero, whereas the alternative hypothesis is that the CAR is unequal zero: H 0 : CAR j = 0 (5) H 1 : CAR j 0 (6) Two sided tests will be performed. All test statistics can be categorized in parametric and non-parametric tests varying in their underlying assumptions. In the following, an explanation of both categories will be provided and differences will be explained. Appendix 6 provides all formulas on which the tests performed are based.

26 20 III.D.i Parametric tests Parametric test statistics for excess return in the event window are based on a standard t- test. It is tested whether the difference between two means is zero (H 0 ). In this event study, the numerator of the test statistics measures the effect of the M&A deal announcement on the stock price. This is calculated relative to the expected or normal return using the market model. The denominator adjusts this number by an estimated variance specific to the test statistic (Bartholdy et al. 2007). Hence, each test differs from another in the way they scale for a problem encountered in the data ( Bartholdy et al. 2007; Brown & Warner 1985). When performing parametric tests, underlying assumptions about the distribution of the sample are made. In order to obtain reliable results, four assumptions need to hold. According to Brown & Warner (1985), the abnormal return is assumed to be independent and normally distributed. Furthermore, the sample must have a constant variance (homoscedasticity) and it must be possible to measure the observations on an interval scale. Particularly, the assumption of normality must be stressed. In section IV.B, the results of the test of normality are presented and further explained. In this event study the following five parametric tests will be performed. T1: Ordinary t-test T2: T-test with adjusted cross sectional dependence (Brown & Warner 1985) T3: T-Test with standardized excess return and adjusted cross sectional independence (Brown & Warner 1980, 1985) T4: Boehmer, Musumeci, and Poulsen s (BMP) t-test (Boehmer et al. 1991) T5: T-test with Patell-adjusted excess return (Patell 1976) Early event studies on the NYSE confirm that standard parametric tests are well specified. Later, these standard tests were advanced leading to robustness and good test power. However both, the Patell t-test and BMP t-test do generally not perform as well as other tests when the sample distribution departs from normality (Corrado 2011). Further, Bartholdy et al. (2007) and Corrado & Truong (2008) found that when using the BMP t-test, the null hypothesis is rejected too often in event studies on the AMEX, National Association of Securities Dealers Automated Quotations (NASDAQ), stock exchanges in the Asia-Pacific region, and the Copenhagen stock exchange (CSE).