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«Does Overvaluation Lead to Bad Mergers? Weihong Song* University of Cincinnati Last Revised: January 2006 * Department of Finance, University of ...»

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Does Overvaluation Lead to Bad Mergers?

Weihong Song*

University of Cincinnati

Last Revised: January 2006


Department of Finance, University of Cincinnati, Cincinnati, OH 45221. Phone: 513-556-7041; Email:

weihong.song@uc.edu. I thank my dissertation committee chair Edie Hotchkiss for continuous guidance and valuable

discussions. The helpful comments of Pierluigi Balduzzi, Rich Evans, Wayne Ferson, Shourun Guo, Cliff Holderness,

Ed Kane, Mark Liu, Norman Moore, Jeff Pontiff, Jun Qian, Armin Schwienbacher, Phil Strahan, Hassan Tehranian, and seminar/conference participants at Boston College, University of Cincinnati, the 4th Asian Corporate Governance Conference (2005, Korea), the Eastern Finance Association annual meetings (2005), and the Financial Management Association annual meetings (2005) are gratefully acknowledged. All remaining errors are my own. An earlier version of this paper was circulated under the title “Managerial Market Timing of Mergers: Evidence from insider trading and long-term performance”.

Does Overvaluation Lead to Bad Mergers?

Abstract This study tests overvaluation as an explanation for merger and acquisition activity by examining whether insider trading patterns of acquiring firm around acquisition announcements are related to long-term post-acquisition performance, and provides evidence on the consequences of acquisitions motivated by overvaluation. My findings show that there is a sharp contrast in the behavior of insiders from my earlier sample period (1986-1996) and the later “hot market” period (1997-2000). For the hot market period, there is a dramatic peak in the average number of shares sold by top insiders of acquiring firms in the month before the acquisition announcement date, followed by another sharp spike in sales when the deal approaches completion. These large increases in insider selling around the acquisition announcement are driven by firms whose insiders are “pure sellers.” This behavior is not observed for the earlier time period. For acquisitions occurring during the “hot market” period, acquirers whose insiders are “pure sellers” significantly underperform their control firms three years following the acquisitions, while acquirers whose insiders are “pure buyers” do not. Moreover, only “pure seller” acquirers experience deterioration in abnormal operating performance from the year before to three years after the acquisition, implying that these mergers are “bad mergers”. Overall, the evidence that pure sellers are associated with worse long-term stock performance even after controlling for the “bad merger” effect indicates that overvaluation is an important motive for acquisitions. The evidence also suggests that the agency costs of overvalued equity described by Jensen (2005) could be an important explanation for wealth destroying deals in the late 1990s.

JEL classification: G34, G38 Keywords: Overvaluation, bad merger, insider trading, and long-term stock performance.

Two institutional shareholders said they filed suit against AOL Time Warner Inc., accusing Chairman Steve Case and other top executives of insider trading as part of 2001 merger while using "tricks, contrivances and bogus transactions" to inflate the company's share price. ⎯ CNN Money, April 14, 2003 I. Introduction In the late 1990s, the U.S. experienced the largest wave of mergers and acquisitions (M&A) in history. The M&A activity in this period differed from that of earlier waves in some important respects. The first distinction is the relatively frequent use of equity as the method of payment for these transactions. Related to this, these transactions were completed during a time period of tremendously high overall equity market valuations. Moeller, Schlingemann and Stulz (2005) suggest that many deals completed during this time period were value destroying.1 Two recent theories examine the link between high equity valuations and merger activity.

Shleifer and Vishny (2003) argue that mergers and acquisitions may occur for the sole reason that overpriced stock can be used as cheap currency to buy real assets. This theory implies that these acquisitions are beneficial to acquiring firm’s original shareholders even though the stock price later falls. Jensen (2005) suggests that “agency costs of overvalued equity” can manifest themselves in value-destroying mergers and acquisitions. When a firm’s equity becomes substantially overvalued, instead of attempting to eliminate overvaluation, managers attempt to meet the market’s growth expectations by engaging in value destroying acquisitions. Once the market learns the high value and growth was an illusion, firm value will fall dramatically. In addition to the disappearance of overvaluation, part or all of the core business value may be destroyed. This implies that not only will the overvaluation eventually be corrected, but also that operating performance will deteriorate following the completion of such poor-quality acquisitions.

Moeller, Schlingemann and Stulz (MSS (2005) hereafter) report that between 1998 and 2001 acquiring firm shareholders lost a total of $240 billion, or 12 cents per dollar spent on acquisitions in the three-day period around acquisition announcement. These losses are concentrated in 87 large loss transactions.

The common theme behind these two theories is that overvaluation is a motive for acquisitions, but their implications on consequences of these acquisitions are different. 2 Both theories have empirical implications for long-term performance. Stock price decline is expected as valuations are later realized. Both models are most applicable to the later “hot market” period.

Further, the model of Shleifer and Vishny is only applicable to stock mergers. Jensen’s, while may be more applicable to stock deals, is broadly to either stock or cash transactions. Shleifer and Vishny (2003) implies that stock mergers motivated by overvaluation were in best interest of acquirer shareholders. Jensen (2005), however, predicts that overvaluation leads to “bad mergers” which reduce core value of the firm. His model suggests long-term deterioration in operating performance. Although some anecdotal evidence has been provided, previous studies have not offered large sample empirical evidence on the real effects of overvalued equity. As argued by Jensen (2005), elimination of overvaluation is not value destruction because the overvaluation would disappear anyway. This suggests that value-destroying mergers should have real effects, in addition to the subsequent stock price decline.

If managers intentionally make acquisitions when their firms are overvalued (and they know it), the same private information presents opportunities for trading by these insiders.

Therefore, using managers’ own portfolio decisions as a window into their beliefs, I can observe whether their behavior is consistent with the belief that their firm is overvalued.3 If managers’ motive for acquisitions is their overvalued share price, holding constant other reasons for trading, I expect managers of acquirers to be net sellers of their stocks. Further, I expect a strong relation Rhodes-Kropf and Viswanathan (2004) propose another theoretical model in which firm-specific and market-wide misvaluations can cause merger waves.

Jenter (2005) provides evidence that managers’ views of fundamental value diverge systematically from market valuations, and argues that we can use managers’ own trading decisions as a window into their beliefs on firm’s valuation. Previous insider trading studies show that firm insiders can identify mispricings of their own companies and that they trade for their personal accounts on this information. See Jaffe (1974), Finnerty (1976) and Seyhun (1986, 1988, 1990b).

between insider trading of acquiring firms prior to the acquisition announcement and long-run post-acquisition performance.

My study is based on a sample of 1,356 acquisitions made by U.S. firms from 1986 to 2000 with insider trading data available. Seyhun (1990b) examines the insider trading behavior of acquiring firms using a sample of acquisitions from 1975 to 1986, and tests whether acquirer managers knowingly overpay for targets so as to benefit themselves personally. He finds that top managers of acquirers increase their net purchases rather than sales prior to takeover announcements.4 My findings show that there is a sharp contrast in the behavior of insiders from my earlier sample period (1986-1996) and the later “hot market” period (1997-2000). 5 Not coincidently, the largest merger wave in U.S. history emerges and a dramatic increase in the number of deals is observed during this period. For the hot market period, there is a dramatic peak in the average number of shares sold by top insiders of acquiring firms in the month before the acquisition announcement date, followed by another sharp spike in sales when the deal approaches completion. These large increases in insider selling around the acquisition announcement are driven by “pure sellers,” defined as firms for which there are only insider sale transactions during the 6-month period ending on, and including the acquisition announcement. 6 This behavior is not observed for the earlier time period.

I next relate these patterns in insider trading around the acquisition announcement both to abnormal returns at the announcement and to long term stock and operating performance.

According to the signaling model of insider trading of John and Mishra (1990), announcement Boehmer and Netter (1997) examine insider trading around corporate acquisitions during 1982-1988 and find little cross-sectional differences in the trading patterns of all managers around an acquisition depending on whether the insiders’ firm itself was subject to a takeover bid.

As documented in Shiller (2000), there is an enormous spike in price-earnings ratios of the S&P Composite Index since 1997, with the ratio rising until it hits an historical high of 44.3 by January 2000.

Similarly, an acquiring firm is defined as “pure buyer” firm if there are only insider purchase transactions during this period. “No trading” firms are acquirers without any insider trade transactions during the prior six-month period.

“Mixed trading” firms are those with both insider buying and selling six months prior to the announcement.

period returns should be most negative when insider selling prior to the acquisition announcement is highest. For the full sample, the mean 2-day CAR for the pure buyer group is -0.59% (significant at 5% level), whereas the comparable figure in the pure seller group is -1.32% (significant at 1% level). The difference in the mean CARs between these two groups is also significant (0.73%, at 5% level), consistent with the prediction of John and Mishra (1990). 7 Interestingly, the difference in announcement period returns between pure buyers and pure sellers varies over time. The earlier time period shows significant difference in both mean and median announcement period CAR between pure sellers and pure buyers, while the later hot market period does not. This may not be surprising, however, given the increased use of executive stock options as a popular form of compensation in recent years, the market may expect firm insiders to sell stock for diversification reasons. Therefore, the market does not, on average, interpret insider sales during the hot market period as a signal of negative information.8 However, we do not observe significant difference in announcement CAR between “pure seller” acquirers and “pure buyers” in the hot market period. The importance of this result is that it highlights the contrast both in behavior between these time periods and the market’s interpretation of that behavior.

I next find that insider trading is strongly related to long-term post-acquisition stock performance during the hot market period (1997-2000). For acquisitions occurring during this period, the mean 3-year buy-and-hold abnormal return following acquisitions is –11.51% (pvalue=0.027). However, when the acquiring firms are “pure sellers”, the average 3-year buy-andhold abnormal return is –19.34% (p-value=0.012). For acquiring firms whose insiders are “pure buyers”, long-run abnormal stock performance is generally positive but insignificant. These results The John and Mishra model depends on availability of insider trading information to the market at the acquisition announcement. The results on announcement period returns using the reporting date to classify insider trading pattern groups are qualitatively similar to those using the transaction date.

Meulbroek (2000) finds that insider selling in Internet-based companies from 1996 to 1998 does not produce negative excess returns.

are robust to alternative abnormal return measurement methodology such as calendar-time abnormal returns. I do not find similar results for the earlier period (1986-1996); the mean 3-year post-acquisition abnormal returns are generally insignificant for both pure buyers and pure sellers.

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