Executive Summary:
Who Gets the Wealth in Mergers and Acquisitions?
The value of merger and acquisition activities in 2001 exceeded $700 billion. The year 2000 witnessed $1.28 trillion worth of these deals. The burning question of how bondholders do in mergers now has a body of documented evidence. There were a number of studies in the ‘60s, ‘70s, and ‘80s, but none had conclusive, reliable evidence due to poor data, small sample size or simply being out-of-date. Head of Finance David Mauer, Assistant Professor Tao-Hsien Dolly King, and University of Iowa’s Matthew Billett have documented their findings in “Bondholder Wealth Effects in Mergers and Acquisitions: New Evidence from the 1980s and 1990s” published in the February issue of the Journal of Finance.
A Brief Background
“We were sitting in my office one Friday, discussing how we have this wonderful new database, the fixed income database, and nobody seems to be using it to answer the obvious,” narrated Mauer. “Researchers were going all over the map with other issues. We figured we had better check all the usual suspects out to see who might be researching this. Surprisingly nobody was.” This study fills the knowledge gap by examining the effects of 940 mergers and acquisitions on the wealth of 3,901 target firm and acquirer firm bonds from the period 1979 to 1997.
The Major Findings
As put forth by existing peer theory, when two firms are merged which have no economic synergies, the bondholders benefit at the expense of the stockholders. This is called the coinsurance effect, e.g., risky debt benefits from the combined assets of the merged firm reducing the risk of default; a wealth transfer occurs from equityholders to the debtholders. “We knew that acquiring firms didn’t do well, and target firms benefited from the premium paid by the acquirer,” explained Mauer. But some details in the findings refute prior suppositions.
In sharp contrast with previous studies, strong evidence was found of the coinsurance effect for target firm bonds. Target bonds earn a significantly positive average excess return of 1.09% during the announcement period. Additionally target bond wealth effects are highly dependent on the risk of the bond. Below investment grade bonds, junk bonds, earned a mean excess return of 4.80%, a highly significantly different wealth effect compared to their investment grade counterparts. In other words, if you have risky debt, those bondholders fare well in the acquisition. Shareholders of the target firm also do very well (which was generally understood) earning a 22.15% mean excess return.
In general, investment grade bonds do not perform very well; target bonds experienced a mean excess return of –0.80 % and acquirer bonds only –0.17 % with no significant difference for investment grade or below investment grade bonds. In contrast with previous empirical work, acquirer bonds experience a significantly negative return. Also inconsistent with peer theory, stockholder and bondholder returns tend to be positively correlated, indicating no wealth transfers.
Other findings in the study point to a rich set of differences in target and acquirer excess bond returns when the sample is stratified by firm and deal characteristics.
Target bonds have significantly larger mean excess returns when:
• The target bond rating is below the acquirer’s;
• When the combination is anticipated to decrease risk or leverage for the target; and
• When the target’s average bond maturity is shorter than the acquirer’s average bond maturity.
Target and acquirer excess bond returns are also significantly larger when:
• The target is relatively small;
• The offer is not characterized as hostile; and
• When the offer occurs in the 1990s.
The latter result coincides with an increase in the use of event risk covenants for the target bonds in the sample during the 1990s in comparison to the 1980s.
Implications
How bondholders will fare in a merger affects how much an acquirer might be willing to pay for a target and the success of the acquisition. “It is terribly important to factor how bondholders will do into the equation. What these results are saying is that the world is a much more complex than was previously thought. If you have risky debt, those bondholders tend to do well in the acquisition,” Mauer recounted. “Furthermore, if as a result of the acquisition, the bondholders are going to do very well and the shareholders are not going to gain—that’s not consistent with shareholder wealth maximization. These factors need to be taken into consideration when weighing whether to do or not do the acquisition.”
This study documents for both academics and those outside academia who gains and who doesn’t in mergers and acquisitions. It was known that acquiring firms’ stockholders didn’t do particularly well in a merger, nor do acquiring firm bondholders. But target firm bondholders, below investment grade, do considerably well. This is an extremely important documented finding that other studies had not uncovered. This information feeds into decisions about how a merger is structured—do you have to worry about the bondholders? “The findings suggest that if you have outstanding investment grade bonds they don’t do well on average as a result of the acquisition,” Mauer continued. “It suggests that bondholders believe there are no economic synergies or coinsurance benefits. However, if they are below investment grade bonds, there are coinsurance benefits.”
The fact that investment grade bonds don’t perform well is consistent with the idea that the majority of acquisitions don’t have any economic synergies associated with them. “My overall interpretation is consistent with this idea,” Mauer expressed. “As a part of the puzzle, the only groups really benefiting are target firm shareholders and below investment grade target bondholders. This could make firms think twice about merging—it’s a huge implication.”
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