Thriving on a Short Leash: Debt Maturity Structure and Acquirer Returns

Thriving on a Short Leash: Debt Maturity Structure and Acquirer Returns Abstract This research empirically investigates the relation between debt maturity structure and acquirer returns. We find that short-term debt is positively related to acquirer returns and this relation is concentrated in financially constrained acquirers. Further analysis reveals that financially constrained acquirers with higher short-term debt ratios are more likely to use stock as payment consideration, pay lower bid premiums, and tend to select acquisition targets with relatively lower short-term debt ratios. These acquisition terms and target selection ease the financial bind of short-term debt and reduce the acquiring firms investment sensitivity of cash flows, thus mitigating their underinvestment and increasing shareholder value. JEL classifications: G32, G34 Keywords: Merger and Acquisition; Debt Maturity; Acquirer Returns; Financial Constraints. 1. Introduction The debt maturity structure is an integrated part of a firm s overall financial policy and closely related to other corporate policies, such as investment and liquidity (e.g., Myers 1977, Jensen 1986, Graham and Harvey 2001, Billett et al. 2007). In a frictionless world, firms can finance all positive net present value (NPV) investment projects (Modigliani and Miller 1958) and the corporate debt maturity structure should be irrelevant to corporate investments. However, in reality, financing frictions distort investments (Graham and Harvey 2001) and corporate debt maturity relates significantly to investments (e.g., Myers 1977, Gertner and Scharfstein 1991, Aivazian et al. 2005, Diamond and He 2014). Custodio et al. (2013) report that although the level 1

of financial leverage of U.S. companies was fairly stable over the period 1976-2008, their debt maturity shortened significantly, largely due to a fundamental change in the composition and nature of firms publicly listed in the 1980s and 1990s and credit supply side factors. Evidence of the effect of short-term debt on investments appears to be mixed. Myers (1977) argues that short-term debt can help firms avoid underinvestment due to the debt overhang problem. In line with this argument, Aivazian et al. (2005) report a negative relation between corporate debt maturity and capital expenditures. However, Gertner and Scharfstein (1991) suggest that, conditional on ex post financial distress, the shortening of debt maturity may imply value transfer from equity holders to creditors, which increases the market value of debt and thus the firm s market leverage, leading to more debt overhang. Almeida et al. (2011) report a negative relation between debt which was scheduled to mature during the 2007-2008 credit crisis and capital expenditures. Yet, Diamond and He (2014) show analytically that short-term debt can either reduce or increase the debt overhang problem depending on firms future prospects and the value of existing assets. Mergers and acquisitions (M&As) are strategically important and observable investments of the acquiring firms. Previous research suggests that M&As represent managers discretionary risk-taking, which can alter the acquiring firms risk profile (Furfine and Rosen 2011, Phan 2014). Moreover, M&As can exacerbate the agency problems that arise from the divergence of interests between shareholders and managers or between shareholders and creditors (Jensen and Meckling 1976, Jensen 1986). These observations suggest that M&As can provide a useful setting in which to examine the effects of corporate debt maturity structure on investments and acquirer shareholder value. A recent study by Fu and Tang (2015) reports a negative relation between short-term debt and its acquisitiveness and a positive relation between short-term debt and acquirer 2

shareholder value. However, because short-term debt can mitigate the free cash flow agency problem, alleviate underinvestment, or constrain firms investment and financing behaviors, all of which can create value for acquirer shareholders, it remains unclear how short-term debt affects acquirer shareholder value. This study focuses on identifying the drivers of the relation between short-term debt and acquirer returns. The agency problem of free cash flow suggests that managers of firms with substantial free cash flows may pursue activities that serve their own interests, such as empire building, which adversely affects shareholders benefits (Jensen 1986). Jensen argues that debt, in addition to dividends, can mitigate this agency problem because it obligates the borrowing firms to follow a fixed repayment schedule, thereby reducing the resources at the managers discretion. Between short-term and long-term debt, the former can be more efficient in restricting managerial discretion because it exposes the borrowing firms to liquidity risk and increases the creditors control right to discipline the management (e.g., Calomiris and Kahn 1991, Diamond 1991, Leland 1998, Benmelech 2007). Previous research suggests that firms in the low and high end of the rating spectrum are more likely to borrow short-term debt. Diamond (1991, 1993) argues that a firm with high credit quality may choose short-term debt financing to avoid the debt overhang problem or to mitigate information asymmetry (i.e., the firm may wait for more information to be revealed to the public then borrow at a lower debt cost). Alternatively, financially constrained firms could be screened out of the long-term debt market due to creditors concern about the asset substitution problem; if so, they can borrow only short-term debt from lenders. Thus, the liquidity risk associated with short-term debt financing can exacerbate the borrowing firm s financial constraint. These arguments indicate that short-term debt can affect acquirer shareholder value by mitigating the free 3

cash flow agency problem, alleviating the debt overhang problem, or motivating firms to follow prudential investment and financing policies as it exposes firms to liquidity risk. We begin our analysis by examining the effects of corporate debt maturity on acquirer M&A announcement abnormal stock returns. Following previous research (e.g., Johnson 2003, Brockman et al. 2010), we use the ratios of a firm s debt maturing within two and three years to its total debt (which we label ST2 and ST3, respectively) as alternative proxies for the firm s short-term debt. Our cross-sectional regression analysis reveals a positive relation between acquirers pre-merger short-term debt ratios and their 3-day cumulative abnormal stock returns (CAR(-1, 1)) centered on M&A announcement days. Our estimation indicates that, depending on the short-term debt measure, a one-standard-deviation increase in the pre-merger short-term debt ratio is associated with an increase of 50-60 basis points (i.e., 0.50%-0.60%) in CAR(-1, 1), which is equivalent to approximately $21.1 million-$25.3 million for an average acquirer. Because financial leverage and debt maturity structure are closely related and previous research has established the link between financial leverage and M&As (Harford et al. 2009, Uysal 2011), we control for financial leverage, among other factors, in our analysis; however, our finding is insensitive to financial leverage control. To examine whether short-term debt mitigates the acquirers free cash flow agency problem, we estimate the CAR regression models augmented with an interaction between short-term debt and excess cash, which proxies for free cash flows. If the positive effect of short-term debt and acquirer shareholder value arises from its power in alleviating the free cash flow agency problem, we expect the interaction between short-term debt and excess cash to be positive and significant. On the other hand, to test the constraint effect of short-term debt, we run the CAR regression models for the subgroups of acquirers sorted on their Standard & Poor s 4

(S&P) long-term credit ratings, which proxy for the degree of financial constraints. 1 Specifically, we sort acquirers into subgroups with S&P long-term investment grade ratings (i.e., financially unconstrained subgroup) or with ratings below investment grade or no ratings (i.e., financially constrained subgroup). Consistent with the view that short-term debt exacerbates a firm s financial constraint, we expect the positive effect of short-term debt on acquirer shareholder value to be more pronounced for financially constrained firms. The results of our CAR regressions augmented with an interaction between short-term debt and excess cash indicate that the interaction effect is insignificant, which is inconsistent with the argument that the positive effect of short-term debt on acquirer CARs arises from its power to curb the agency problem of free cash flows. In contrast, the CAR regression results for the financially constrained and unconstrained subgroups show that short-term debt has a positive (insignificant) effect on shareholder value of financially constrained (unconstrained) acquiring firms. Firms self-select to pursue or not to pursue M&As and, all else being equal, they are more likely to pursue M&A deals that create larger shareholder value. This observation indicates that our cross-sectional regression is prone to the self-selection problem which potentially biases the coefficient estimates. We use the Heckman (1976, 1979) two-step self-selection correction model to address the self-selection bias problem but our findings are qualitatively unchanged. Collectively, our evidence suggests that the financial bind imposed by short-term debt financing 1 Our results are qualitatively similar if we use sample split based on the level of acquirers free cash flows to examine the effect of short-term debt on acquirer CARs. On the other hand, because financially constrained firms could be screened out of the long end of the maturity spectrum, we use the sample split based on financial constraint measures to examine the effect of short-term debt on acquirer CARs to avoid the collinearity between short-term debt and financial constraint measures. 5

on financially constrained firms drives the positive relation between short-term debt and acquirer shareholder value. To explore potential mechanisms through which short-term debt affects acquirer returns, we investigate the relations between the debt maturity structure and the selection of M&A targets, the change in debt maturity structure of the acquirers from before to after M&A deals, the payment consideration, and the bid premiums. Custodio et al. (2013) suggest that a firm with larger short-term debt financing must refinance more frequently and is more likely to be financially constrained. Diamond (1991) and Guedes and Opler (1996) argue that short-term debt could be imposed on borrowing firms, particularly those with low credit quality, by creditors rather than the borrowers choice. Previous research has also shown that acquiring firms can use M&As to alter their capital structure (Leary and Roberts 2005, Flannery and Rangan 2006, Kayhan and Titman 2007, Harford et al. 2009, Uysal 2011). Moreover, Erel et al. (2014) report that M&As can ease target firms financial constraints so these firms hold less cash reserves, have lower investment-cash flow sensitivity, and invest more after the M&As. Thus, to the extent that short-term debt constrains a firm s investments and financing, we expect that firms constrained by short-term debt are more likely to use stock as M&A currency and to pay lower bid premiums. Furthermore, we expect an acquirer with a large pre-merger short-term debt ratio to select an acquisition target with a relatively lower short-term debt ratio, which helps the acquirer to alter its debt maturity structure and improve its ability to meet short-term debt repayment obligations with the combined cash flows of the acquirer and the target. Our analysis results show a positive (negative) effect of short-term debt on the stock payment likelihood (acquisition bid premiums), which is consistent with our expectation. We also run the payment consideration and bid premiums regressions separately for subgroups of 6

financially constrained and unconstrained acquirers then compare the effects of short-term debt on the outcome variables of the two subgroups. The results indicate a stronger effect for the subgroup of financially constrained acquirers. Our investigation of the target selection indicates that the acquirers burdened with short-term debt financing tend to select targets with relatively lower short-term debt ratios and these acquirers experience a significant decrease in their short-term debt ratio from before to after the M&A deal. Further analysis suggests that these results are not likely to be driven by the acquirers new long-term debt financing or a substitution of long-term for short-term debt. We next investigate how the reduction in short-term debt affects acquirers post-merger investment, which could potentially be a channel through which short-term debt affects acquirer shareholder value. Similar to Erel et al. (2014), we employ a conventional investment regression model in which the dependent variable is capital expenditures and the independent variables include lagged Tobin s Q, which proxies for investment opportunities, and cash flows (Fazzari et al. 1988), but we augment it with the AFTER dummy variable (which takes a value of 1 for a firm-year observation after an M&A deal, and 0 otherwise) and its interaction with cash flows. In a frictionless world, a firm s investments should depend on its investment opportunities but not its cash flows; however, Fazzari et al. point out that financially constrained firms investments are sensitive to their cash flows. To the extent that the acquiring firms can ease financial constraints after M&A deals, we expect a decrease in their investment-cash flow sensitivity evidenced by a negative and significant coefficient on the interaction between the AFTER dummy variable and cash flows. We run separate investment regressions for two subgroups of acquirers sorted on their changes in short-term debt ratios around the M&A deals relative to the sample median changes and focus our analysis on the period starting 3 years before M&A announcements and ending 3 7

years after the deal completion. We find a significant decrease in investment-cash flow sensitivity for the subgroup of acquirers with a large decrease in short-term debt, but an insignificant change for the other subgroup of acquirers. This result implies that a financially constrained acquirer that manages to reduce the financial bind of short-term debt through an acquisition deal is more likely to invest at the first-best level following the acquisition. Finally, we examine the relation between the change in acquirers short-term debt and their long-term stock performance. We use acquirer buy-and-hold abnormal returns (BHARs) over the 1-, 2-, and 3-year periods following M&A deal completion as a proxy for acquirer long-term stock performance. Our evidence indicates that a decrease in acquirer short-term debt ratios from pre- to post-merger is associated with an increase in their long-term stock performance. This finding is robust to controlling for either the level of or the change in acquirer financial leverage and is more pronounced for financially constrained acquirers. Collectively, our evidence indicates that short-term debt financing imposes financial bind on financially constrained acquirers, which motivates them to be prudent with the acquisition terms and the selection of acquisition targets. Their acquisition terms and target selection ease the financial bind of short-term debt and reduce the investment sensitivity of cash flows, thus mitigating the suboptimal investment problem and increasing acquirer shareholder value. Our research contributes to the literature in three ways. First, this research adds to a stream of literature that examines the interdependence of corporate financial policies and investments in the presence of financial frictions (e.g., Jensen and Meckling 1976, Fazzari et al. 1988, Whited 1992, 2006, among others). We show that reducing the short-term debt can help financially constrained firms alleviate corporate underinvestment. Second, Smith and Kim (1994) report that an acquisition that combines a firm with financial constraint with a firm with financial slack can 8

create value. Erel et al. (2014) find that M&As can relieve targets financial constraints. Our research provides complementary evidence that acquirers can also ease their financial constraints through M&As. Finally, this research complements prior studies that investigate the motivations of acquirers in selecting acquisition targets (e.g., Harford et al., Uysal). We find that, by acquiring targets with relatively lower short-term debt ratios, acquirers constrained by short-term debt financing can alter their debt maturity structure, thus lowering liquidity risk and easing financial constraints. 2 Our evidence also indicates that the effects of the debt maturity structure on M&As and their outcomes are above and beyond those of financial leverage. Our research is related to that of Fu and Tang (2015), who also investigate the relation between debt maturity and acquisition decisions. However, our research is different from theirs in two important ways. First, we focus on the drivers of the positive relation between short-term debt and acquirer shareholder value. Fu and Tang assume that the positive effect of short-term debt on acquirer shareholder value is driven by the high rated (i.e., financially unconstrained) acquirers willingness to refinance short-term debt, and that these firms will engage in value-increasing acquisitions because their high credit ratings facilitate refinancing of the maturing short-term debt; however, they do not explore this assumption empirically. We show direct empirical evidence, which is contrary to their assumption, that the positive relation between short-term debt and acquirer returns is concentrated in acquirers with low or no ratings, i.e., financially constrained firms. Second, we identify the mechanisms through which short-term debt affects acquirer shareholder value. In particular, we show that financially constrained acquirers burdened with short-term debt financing are more likely to use stock as payment consideration, pay lower bid 2 Although firms are unlikely to pursue M&As only for the sake of altering their debt maturity structure, which could be costly, they may consider changing the debt maturity structure as a part of the overall M&A strategy. 9

premiums, select targets with relatively lower short-term debt ratios, and reduce their short-term debt ratios after the deal completion. The target selection and acquisition terms reduce the refinancing risk of the acquiring firms, ease their financial constraints, and lead to an increase in acquirer shareholder value. The remainder of the paper is organized as follows. We present a description of the data and variables construction in section 2. Section 3 discusses the empirical predictions, models and results. Section 4 presents robustness checks and Section 5 concludes the paper. 2. Sample, Variable Construction, and Descriptive Statistics We obtain M&A data from the Securities Data Company s (SDC) Platinum Database. Following the literature, we filter out small deals with a value below $1 million and a deal ratio, measured as the deal value divided by the acquirer s market value of equity at the end of the fiscal year preceding the M&A announcement, below 5%. We exclude acquirers from the utility and financial industries (Standard Industrial Classification (SIC) codes from 4900-4999 and from 6000-6999, respectively) because firms in these industries are highly regulated. We obtain accounting data from Compustat and stock price and return data from the Center for Research in Securities Prices (CRSP) database. We further exclude M&A deals that have missing important acquirer characteristics used in our cross-sectional analysis, such as market-to-book ratio, past 12-month returns, and announcement stock returns. The final sample includes 3,830 M&A deals of 2,094 unique firms over the period 1986-2013. 3 3 Our sample size is smaller than that of Fu and Tang (2015) because we impose the minimum deal ratio of 5%, whereas Fu and Tang impose the minimum deal ratio of 1%. 10

Following previous research (e.g., Johnson 2003, Brockman et al. 2010), we measure short-term debt as the ratio of a company s debt maturing within two and three years to its total debt and label these measures ST2 and ST3, respectively. 4 Total debt is the sum of debt in current liabilities and long-term debt as reported in Compustat. We use these alternative proxies for short-term debt in our analysis. Appendix A provides the definitions of the variables. Table 1 reports the annual and 2-digit SIC code industry distributions of the M&A sample in Panels A and B, respectively. The number of M&A deals increased gradually from the beginning of the sample period to 2006, dropped significantly in 2007 when the Great Recession took place, but increased again in recent years. Industries that experienced large numbers of M&As include business services, electronic and electrical equipment, instruments and related products, chemicals and allied products, oil and gas extraction, industrial, commercial machinery and computer equipment, transportation equipment, health services, food and kindred products, wholesale trade - durable goods, primary metal industries, and engineering and management services. [Insert Table 1 about here] Table 2 reports the summary statistics of the sample. The statistics indicate that short-term debt accounts for a significant part of the sample firms total debt. The means of ST2 and ST3 are 0.35 and 0.47, respectively. The average past 12-month stock return of the acquiring firms is 17%. The acquirers average 3-day M&A announcement CAR is 1.90%. Acquiring firms appear to be large and have high sales growth rates and market-to-book ratios. 4 Specifically, debt maturing within two years is the sum of debt in current liabilities and debt maturing in the second year. Debt maturing within three years is the sum of debt in current liabilities and debt maturing in the second and third year. Our findings are qualitatively unchanged if we use the ratio of debt maturing within one year or four year as a proxy for a firm s short-term debt. 11

[Insert Table 2 about here] 3. Empirical Predictions, Models, and Results 3.1. Debt Maturity Structure and Acquirer M&A Announcement CARs The agency problem of free cash flows suggests that self-interested managers can use free cash flows for empire building that destroys shareholder value (Jensen 1986). Harford (1999) documents that managers of cash-rich firms are more likely to attempt acquisitions and acquisitions by these firms are generally value destroying. Furfine and Rosen (2011) and Phan (2014) document that M&As are positively related to corporate managers discretionary risk-taking and, on average, they increase acquirers default risk post-merger. Jensen suggests that debt, in addition to corporate payouts, can mitigate the agency problem of free cash flows because it obligates the borrowing firms to follow a fixed repayment schedule, which reduces the cash at managers discretion. Between long-term and short-term debt, the latter can be more effective in restricting managers discretion, particularly in large and long-term investments like M&As, because it exposes firms to frequent refinancing and default risk if they fail to roll over debt when it matures (Barnea et al. 1980, Sharpe 1991, Rajan and Winton 1995, Leland and Toft 1996). Previous research suggests that firms in the low and high end of the rating spectrum are more likely to borrow short-term debt. Diamond (1991, 1993) argues that a firm with high credit quality may use short-term debt financing to avoid the debt overhang problem or to mitigate information asymmetry (i.e., the firm may wait for more information to be revealed to the public then borrow at a lower debt cost). Alternatively, it is possible that financially constrained firms are screened out of the long-term debt market; if so, they can borrow only short-term debt from lenders. Thus, 12

short-term debt financing could exacerbate the borrowing firms financial constraints. The foregoing arguments suggest that the positive relation between short-term debt and acquirer shareholder value could arise from the short-term debt s power in mitigating the free cash flow agency problem, alleviating the underinvestment problem, or motivating prudential investment and financial policies as it exposes firms to refinancing risk. To gauge the effect of short-term debt on acquirer short-term stock performance, we run the cross-sectional regressions of acquirer CAR(-1, 1) and report the results in Panel A of Table 3. We use the market model and value-weighted CRSP index returns to estimate CARs. Similar to prior research (e.g., Baradwaj et al. 1990, Harford 1999, Moeller et al. 2005, Loughran and Vijh 1997, Masulis et al. 2007), we control for the following firm and deal characteristics in our regressions: size, market-to-book ratio, financial leverage, excess cash, past 12-month returns, high-tech dummy, cash dummy, stock dummy, deal attitude dummy, target public status, challenge dummy, and industry M&A intensity. Appendix A provides the definitions of the variables. The estimation results show that short-term debt ratios are positive and significantly related to acquirer CARs. Specifically, the coefficients on ST2 and ST3 are 0.016 and 0.012, respectively, and highly significant. Using the point estimates to calculate the economic effect of short-term debt on acquirer shareholder value, we find that, holding other variables unchanged at their sample means, a one-standard-deviation increase in ST2 and ST3 is associated with an increase of 0.60% and 0.50%, respectively, in shareholder value. Given the average market value of equity of the sample acquirers of $4.21 billion, the increase in shareholder value is equivalent to $25.3 million and $21.1million, respectively, which is economically significant. 5 5 For robustness check, we run the CAR regressions using the short-term debt ratio constructed as the debt in current liabilities divided by book value of assets and use the M&A sample with a deal ratio greater than 1% (9,535 13

Firms self-select to pursue or not to pursue M&As and, all else being equal, they are more likely to pursue M&A deals that create larger shareholder value. Therefore, our cross-sectional regression is prone to the self-selection problem, which potentially biases the coefficient estimates. We use the Heckman (1976, 1979) two-step self-selection correction model to address the self-selection bias concern. Specifically, in the first-step, we estimate an M&A probit model then we use the coefficient estimates to calculate the inverse Mill s ratio (IMR). The dependent variable of the probit model is M&A dummy, which is an indicator that equals 1 if firm i makes at least one acquisition announcement in year t, and 0 otherwise, and the test variable is ST2 or ST3. We follow prior studies in controlling for variables that have power to explain the likelihood of acquisition, including size, market-to-book ratio, financial leverage, momentum, firm age, excess cash, and sales growth. We additionally control for year- and industry-fixed effects by including year dummies and the 2-digit SIC code industry dummies. Appendix A provides definitions of the variables. We report the probit model estimation results in Table A1 in the detachable appendix. The coefficients on short-term debt measures are all negative and statistically significant at the 1% level, indicating that short-term debt is negatively related to a firm s likelihood to pursue M&A deals. 6 In the second step, we rerun the CAR cross-sectional regressions augmented with IMR. observations) while controlling for the ratio of long-term debt to book value of assets and other variables. The estimation results indicate that only the coefficient of short-term debt is positive (0.039) and significant at the 1% level, while the coefficient of long-term debt ratio is insignificant (for brevity, we do not report the results but they are available from the authors). This result is qualitatively similar to the one reported by Fu and Tang (2015). 6 In an unreported analysis, we examine the effect of short-term debt on the acquisitiveness of financially constrained and unconstrained firms separately. We find that the negative effect of short-term debt on acquisitiveness holds for both types of firms. This evidence is inconsistent with the argument that short-term debt can mitigate the debt overhang problem, at least in the M&A context. 14

The cross-sectional regression results reported in columns 3 and 4 of Panel A, Table 3, which control for possible self-selection bias, indicate that our findings are insensitive to the self-selection bias correction. Moreover, the coefficients on IMR are statistically insignificant, implying that the self-selection bias concern is unsubstantiated. The relations between acquirer CARs and other control variables are also consistent with those documented in the literature. For instance, firm size, market-to-book ratio, diversifying acquisition, and public target (financial leverage and cash payment) are negatively (positively) related to acquirer shareholder value. To examine whether short-term debt mitigates the agency problem of free cash flows of the acquiring firms, we run the CAR regressions augmented with an interaction between short-term debt and excess cash, which proxies for free cash flows. Following Opler, Pinkowitz, Stulz, and Williamson (1999), and Harford, Mansi, and Maxwell (2008)), we first estimate cash holdings as a function of firm size, financial leverage, market-to-book ratio, cash flows, standard deviation of the last 10 years cash flows, net working capital, capital expenditures, acquisition spending, dividend expense, S&P credit ratings, and industry and year fixed effects. Then, we calculate excess cash as the difference between the actual and the predicted cash holdings. If the positive effect of short-term debt and acquirer shareholder value is due to the reduction of the free cash flow agency problem, we expect the interaction of short-term debt and excess cash to be positive and significant. Panel B of Table 3 reports the results of the CAR regressions with the interaction of short-term debt and excess cash. The coefficients on the interaction term are statistically insignificant, indicating that the power of short-term debt in mitigating the free cash flow agency problem is unlikely the explanation for the positive effect of short-term debt on acquirer shareholder value. In an unreported analysis, we run the CAR cross-sectional regressions for two subgroups of acquirers with pre-merger positive and non-positive excess cash. We find that 15

short-term debt has positive (insignificant) effect on acquirer returns of the subgroup with non-positive (positive) excess cash. This result is inconsistent with the hypothesis that short-term debt mitigates the acquirers free cash flow agency problem. 7 [Insert Table 3 about here] To investigate the constraint effect of short-term debt, we run the CAR cross-sectional regressions for subgroups of acquirers sorted on their credit ratings. Specifically, we sort acquirers into subgroups with Standard and Poor s (S&P) long-term credit ratings below investment grade or no ratings (i.e., financially constrained subgroup), and with investment-grade ratings (i.e., financially unconstrained subgroup). We use the credit ratings as a measure of the level of financial constraint because acquiring firms typically seek external financing to support payment for large M&A deals and credit ratings feature prominently in external financing. 8 The CAR regression results reported in Panel C of Table 3 show that short-term debt has a positive (insignificant) effect on shareholder value of financially constrained (unconstrained) acquiring firms. Collectively, the results in Panels B and C of Table 3 are consistent with the financial constraint explanation for the positive effect of short-term debt on acquirer stock performance, but inconsistent with the short-term debt s power in mitigating the free cash flow agency problem or the debt overhang problem (for financially unconstrained firms) explanation. Previous studies document that stock payment for M&A targets is typically driven by acquirer stock overvaluation (e.g., Ang and Cheng 2006, Shleifer and Vishny 2003, Rhodes-Kropf 7 In an unreported analysis, we use an alternative measure of free cash flows, which is calculated as operating cash flows minus preferred and common equity dividend payments, all divided by the book value of assets. Our results are qualitatively similar. 8 Our findings are qualitatively similar if we use other measures for financial constraints, such as firm size, market-to-book ratio, dividend payment, and size-age index (Hadlock and Pierce 2010). 16

et al. 2005, Dong et al. 2006) or agency problems (Amihud et al. 1990), which adversely affects shareholder value. To the extent that stock payment is driven by financial constraints associated with short-term debt financing rather than stock overvaluation or managerial agency problems, we expect short-term debt to mitigate the negative effect of stock payment on acquirer shareholder value. We examine the plausibility of this argument by augmenting the CAR regressions with the interactions between short-term debt measures and payment consideration (i.e., stock dummy and cash dummy) and rerun the analysis. The results show that stock payment has a negative effect on shareholder value, which is similar to the findings documented in the literature. More importantly, consistent with our expectation, we find that short-term debt mitigates the negative effect of stock payment on shareholder value (for brevity, we do not report the results but they are available from the authors). 3.2. Debt Maturity Structure, Payment Consideration, and Bid Premiums An acquirer burdened with short-term debt is likely to be concerned about liquidity risk. It may also face a challenge in raising external funds to support payment for an M&A deal, suggesting that stock could be the preferred form of payment. We estimate a payment consideration probit model and report the results in Table 4. The dependent variable is stock dummy, which takes a value of 1 if the payment for the target is fully in stock and 0 otherwise. The coefficients on ST2 and ST3 are positive but only the coefficient on ST2 is statistically significant at the 5% level. This result is consistent with our expectation of a positive relation between short-term debt and stock payment. 9 Among the control variables, market-to-book ratio and target public dummy (acquirer size and relative size) are positively (negatively) related to the stock 9 In an unreported analysis, we also consider the effects of acquirer short-term debt on the proportion of stock payment for acquisition targets and find qualitatively similar results. 17

payment likelihood, but financial leverage is insignificantly related to M&A payment consideration. We estimate the payment consideration regressions with an interaction between short-term debt and excess cash and report the results in Panel B of Table 4. The interaction effect is statistically insignificant. We further run the payment consideration regressions separately for subgroups of acquirers sorted on the S&P long-term credit ratings and report the results in Panel C of Table 4. We find that the positive effect of short-term debt on stock payment likelihood is statistically significant for only financially constrained acquirers. Taken together, the evidence indicates that the financial constraint effect of short-term debt is more likely the driver of the positive relation between short-term debt and stock payment for M&A deals. [Insert Table 4 about here] We turn next to analysis of the relation between the acquirer short-term debt ratio and the bid premiums. If short-term debt imposes a financial burden and/or provides debt monitoring, we expect a negative relation between acquirer short-term debt and the bid premiums. We use the bid premiums calculated based on the bid prices relative to the targets stock prices one week before an M&A announcement as the dependent variable. Following previous research (e.g., Officer 2003, Dimopoulos and Sacchetto 2014), we control for acquirer size, market-to-book ratio, financial leverage, excess cash, momentum, cash payment dummy, stock payment dummy, challenge dummy, and deal attitude. Consistent with our expectation, the bid premiums regression results reported in Panel A of Table 5 indicate that acquirer short-term debt is 18

negatively related to bid premiums. 10 We examine the mitigating effect of short-term debt on free cash flow agency problem and report the results in Panel B of Table 5. The coefficient on ST3 is negative and significant but the coefficients on the interaction terms are statistically insignificant. We also run the bid premiums regressions separately for the subgroups of financially constrained and unconstrained acquirers then compare the effect of the short-term debt ratio on the outcome variables of the two subgroups. The estimation results reported in Panel C indicate that short-term debt has a negative and significant (insignificant) effect on the bid premiums of financially constrained (unconstrained) acquirers. [Insert Table 5 about here] 3.3. Debt Maturity Structure and M&A Target Selection Short-term debt financing exposes the borrowing firms to liquidity risk and a failure to make payment for outstanding debt at maturity may hinder their refinancing efforts (Jensen 1986). A firm that relies heavily on short-term debt financing needs to refinance more frequently and is more likely to be financially constrained (Custodio et al. 2013). However, some studies suggest that borrowing short-term debt allows firms to preserve their borrowing capacity to meet future growth opportunities (Graham and Harvey 2001) and avoid the debt overhang problem (Myers 1977). Our finding of a negative (positive) relation between short-term debt and acquisitiveness (stock payment likelihood) in the previous sections is consistent with the financial constraint effect of short-term debt but inconsistent with the argument that firms use short-term debt financing to 10 The results are qualitatively similar if we use the bid premiums based on the target stock prices measured 4 weeks before the bid announcements. In an additional analysis, we examine the effect of acquirer short-term debt on focusing versus diversifying M&As, but the results are inconclusive. 19

preserve debt capacity for future investment opportunities. In this section, we investigate how the financial bind imposed by short-term debt financing affects the selection of acquisition targets. M&As can alter the acquirers capital structure (Leary and Roberts 2005, Flannery and Rangan 2006, Kayhan and Titman 2007, Harford et al. 2009). Harford et al. and Uysal (2011) show that acquirers increase (decrease) their leverage by using cash (stock) as a medium of payment for M&As. Erel et al. examine a sample of European firms involved in M&As and document that M&As can ease the target firms financial constraints so these firms hold less cash, have lower investment-cash flow sensitivity, and increase investment following the M&As. To the extent that short-term debt imposes constraint on the borrowing firms, and given the typically large capital required to fund M&A deals, we expect acquirers with large short-term debt ratios to alleviate this source of constraint by selecting targets with relatively lower short-term debt ratios. Moreover, we expect a decrease in acquirers short-term debt ratio from the pre- to post-merger period as a result of the selection of targets with relatively lower short-term debt ratios. We perform a univariate analysis of the difference between an acquirer s and its target s short-term debt ratios in the year preceding the M&A announcement and report the results in Panel A of Table 6. We use the t-test (Wilcoxon sign-rank test) to make statistical inferences about the mean (median) of the differences in acquirer-target short-term debt ratios. The results indicate that acquirers, on average, select targets with relatively lower short-term debt ratios. Because the pre-merger short-term debt level of acquirers may influence their selection of acquisition targets, we further compare the differences in acquirer-target short-term debt ratios between the two subgroups of acquirers sorted on their pre-merger short-term debt ratios relative to the sample median. The results reported in Panel B of Table 6 indicate that the difference in acquirer-target 20

short-term debt ratios is more pronounced for the acquirers belonging to the high pre-merger short-term debt ratio subgroup. [Insert Table 6 about here] To address a possible concern that the relation between an acquirer s short-term debt ratio and its target selection may be confounded by the effect of the acquirer pre-merger financial leverage, we sort acquirers into high and low short-term debt subgroups and high and low financial leverage subgroups (i.e., independent double sort) based on their pre-merger values relative to the respective sample medians. We use acquirer book leverage rather than market leverage as a proxy for financial leverage because the latter may change significantly from before to after the M&A deal due to a change in acquirer stock prices rather than their debt financing. We then examine the differences in acquirer-target short-term debt ratios between the high leverage, high short-term debt (HH) subgroup and the high leverage, low short-term debt (HL) subgroup. The analysis results reported in Panel C of Table 6 indicate that acquirers in both subgroups select targets with relatively lower short-term debt ratios. More importantly, we find that the differences in the acquirer-target short-term debt ratios of the HH subgroup are significantly larger than those of the HL subgroup. This evidence implies that the effect of acquirer short-term debt on the acquisition target selection is above and beyond that of financial leverage. In the next analysis, we track the changes in acquirer short-term debt ratios from the year preceding an M&A announcement to each of the 3 years after the M&A deal completion. We label these changes ΔN_ST2 and ΔN_ST3, where N takes a value of 1, 2, and 3 in this analysis. In addition, because the change in short-term debt ratios can be driven by factors shared industry-wide, we also calculate the change in industry-adjusted short-term debt ratios of the acquirers. The change in an acquirer s industry-adjusted ratio is measured as the difference 21

between the acquirer s short-term debt ratio in each of the three years after an M&A deal completion and the contemporaneous industry median short-term debt ratio, then adjusted by the acquirer s respective industry-adjusted short-term debt ratio in the year preceding the M&A announcement (i.e., a difference-in-differences measure). We label the changes in acquirers industry-adjusted short-term debt ratios IA_ΔN_ST2 and IA_ΔN_ST3, respectively. We report the analysis results of the changes in acquirer short-term debt ratios in Panel A and the changes in industry-adjusted short-term debt ratios in Panel B of Table 7. The results in both Panels A and B indicate that acquirer short-term debt ratios decrease after M&A completion: The mean and median changes in acquirer short-term debt ratios are negative and highly significant in the first and second year after M&A completion. In an unreported analysis, we examine the changes in acquirers industry-adjusted short-term debt ratios from before to after M&As for the subgroups of acquirers sorted on either the pre-merger short-term debt ratios or both the pre-merger short-term debt ratios and financial leverage (i.e., independent double sort). We find consistent evidence that acquirers with higher short-term debt ratios before the M&A experience a significantly larger decrease in their short-term debt ratios after the deal completion. [Insert Table 7 about here] To rule out the possibility that our documented decrease in acquirer short-term debt ratios may be due to the acquirers use of new longer term debt financing to support M&A payment, we investigate the change in acquirer financial leverage from pre-merger to each of the three years after M&A completion for acquirers sorted on their pre-merger financial leverage or independently sorted on both the pre-merger financial leverage and the short-term debt ratio. The univariate results indicate that acquirers in the high (low) financial leverage subgroup experience a significant decrease (increase) in leverage from before to after the M&A deal and the changes in 22

leverage are significantly different between the two subgroups. Moreover, the decrease in financial leverage of the high leverage, high short-term debt subgroup is not statistically different from that of the high leverage, low short-term debt subgroup (for brevity, the results are not reported but are available from the authors). This evidence indicates that the decrease in acquirer short-term debt ratios from before to after an M&A deal is not likely to be driven by a concurrent increase in acquirer financial leverage or longer term debt financing. Acquiring firms may substitute longer term debt for mature shorter term debt when they pursue M&As, which can leave their financial leverage intact while increasing debt maturity. To explore this possibility, in an unreported analysis, we examine the change in debt maturity of acquiring firms with speculative-grade credit ratings and no ratings. Because creditors are less likely to provide long-term debt to these firms (Diamond 1991, Guedes and Opler 1996), a decrease in their short-term debt ratios following the M&As is more likely explained by the acquirers selection of targets with relatively lower short-term debt ratios. Our results indicate a significant decrease in short-term debt ratios following the M&As for these acquirers, which is suggestive that debt maturity substitution is not likely to be the driver of our findings. On the other hand, we do not find a significant change in short-term debt ratios of acquirers with investment-grade ratings. In sum, our analysis of acquisition target selection indicates that acquiring firms manage to decrease their short-term debt ratios by acquiring targets with relatively lower short-term debt ratios, thus easing acquirers liquidity risk and financial constraints. 3.4. Corporate Debt Maturity and Investment-Cash Flow Sensitivity In the previous sections, we have shown that acquirers can reduce their short-term debt ratios and ease financial constraints through M&As. In this section, we investigate how the 23

reduction in short-term debt affects acquirers post-merger investment, which could potentially be a channel through which the change in acquirer short-term debt ratios affects shareholder value. To examine this possibility, similar to Erel et al. (2014), we estimate a conventional investment regression model in which the dependent variable is capital expenditures and the independent variables include lagged Tobin s Q, which proxies for investment opportunities, and cash flows (Fazzari et al. 1988), but we augment it with the AFTER dummy variable (which takes a value of 1 for a firm-year observation after an M&A deal, and 0 otherwise) and its interaction with cash flows. Both capital expenditures and cash flows are normalized by the beginning-of-period book value of assets. In a frictionless world, a firm s investments should depend on its investment opportunities but not its cash flows. However, Fazzari et al. (1988) shows that financially constrained firms investments are dependent on their cash flows. Following this line of argument, if the acquiring firms can ease financial constraints after M&A deals, we expect a decrease in their investment-cash flow sensitivity evidenced by a negative and significant coefficient on the interaction between the AFTER dummy variable and cash flows. We focus our investment analysis on the period starting 3 years before M&A announcements and ending 3 years after the deal completion. The investment regression results reported in Panel A of Table 8 show that the coefficients of Tobin s Q and cash flows are positive and highly significant, which is consistent with the evidence documented in the literature. Although we do not find an increase in acquiring firms investment after the M&As (the coefficient on the stand-alone AFTER dummy variable is negative and statistically significant, which could be due to a temporal trend), we find a significant decrease in investment-cash flow sensitivity, which is consistent with our expectation. [Insert Table 8 about here] 24

We run separate regressions for subgroups of acquirers sorted on their changes in short-term debt ratios around the M&A deals relative to the sample median changes and report the estimation results in Panel B of Table 8. The results show a significant decrease in investment-cash flow sensitivity for the subgroup of acquirers with a larger decrease in short-term debt, but an insignificant change in investment-cash flow sensitivity for acquirers in the other subgroup. This evidence implies that an acquirer that manages to reduce the burden of short-term debt post-merger is more likely to invest at the first-best level, leading to an improvement in its long-term stock performance. However, we caution that the interpretation of our results is subject to the standard critique of the investment-cash flow literature because the average Tobin s Q could be a poor proxy for investment opportunities, whereas cash flows could be correlated with investment opportunities not captured by Tobin s Q, implying that the coefficient estimates of cash flows could be biased (Erikson and Whited 2000, Gomes 2001, Alti 2003). 3.5. Corporate Debt Maturity and Acquirer Long-term Stock Performance We next examine the effect of short-term debt on acquirer long-term stock performance proxied by their BHARs. We use the change in short-term debt ratio from before an M&A announcement to after its completion rather than the pre-merger short-term debt level in order to better capture the dynamics of the acquirers financing policy associated with M&As, which can alter not only the acquirer financial leverage but also the debt maturity structure as documented above. We use the matched firm-adjusted method (Barber and Lyon 1997; Lyon et al. 1999) to estimate acquirer BHARs. Specifically, for each sample acquirer, we identify a matched firm in the same 2-digit SIC code industry that has not been engaged in any M&As over the last 3 years, has size measured by the firm s book value of assets within the range of 70%-130% of that of the sample acquirer, and has a market-to-book ratio closest to that of the acquirer. BHAR is calculated 25