Corporate Takeovers
Cash will do nicely

New evidence from the United Kingdom and United States reveals that share prices rise twice as much during cash-financed as during equity-financed acquisitions. This new research was discussed by Colin Mayer, Co-Director of the Centre's ATE programme, at a lunchtime meeting held on July 13. Announcements of cash offers generated greater short-run capital gains for the shareholders of acquired firms than did equity-financed offers, while in the medium term the share prices of firms acquired for equity suffered abnormal losses which were not experienced in the case of cash-financed takeovers. The tax treatment of takeovers could account for only part of these differences, Mayer argued: the periodic mispricing of securities by the market offered a better explanation. Firms have a clear incentive to attempt equity-financed takeovers when their shares are overvalued, and subsequent declines in share price merely reflect the market's reassessment of the acquiring firm's equity.

Colin Mayer is Price Waterhouse Professor of Corporate Finance at the City University Business School. He has published widely on corporate finance and taxation and is the author of CEPR Discussion Paper Nos. 181 and 182 (reported in Bulletin No. 21). His lunchtime talk summarized his research with Julian Franks and Robert Harris, reported in CEPR Discussion Paper No. 200 .

Mayer and his colleagues examined the way in which acquiring companies have paid for acquisitions, using a very large sample of over 1,500 acquisitions in the United States and 900 in the United Kingdom over the period 1955-85. The two most common methods of payment were equity offers (exchanges of the acquiring company's shares for those of the acquired firm) and outright purchases for cash. Mayer noted that in the United States there had been a striking change in the relative frequency of these two methods of acquisition. Until 1965 an exchange of shares was by far the most common method of payment, but by 1985 nearly 70% of firms acquired were purchased for cash. The form of finance employed in UK acquisitions had also changed. In contrast to the US, however, the proportion of acquisitions purchased purely for cash has fallen since 1975. Equity offers with cash alternatives (i.e. offers of either cash or the acquiring company's shares) have emerged instead as the dominant form of payment in Britain.

Mayer's research also revealed a striking difference between cash and equity takeovers in the movements of the share prices of acquired firms on and immediately prior to takeover announcements. 'Bid premia' (the appreciation of the acquired firm's share prices around the time of the merger announcement) are much higher for cash-financed than for equity-financed acquisitions. Shareholders of UK firms acquired for cash enjoyed an average capital gain of about 30% in the month of the acquisition announcement; for equity offers the capital gain was only 15%. In the US the corresponding figures were 25% for cash and 11% for equity offers.
Equity-financed takeovers appeared less beneficial to shareholders in the medium term as well. In the two years after acquisition, there appeared to be no abnormal gains or losses for shareholders involved in a cash-financed acquisition. For an equity-financed acquisition, on the other hand, there was some evidence that shareholders suffered abnormal losses (over and above those accounted for by general market movements). This was particularly pronounced in the US, where shareholders on average sustained abnormal losses of around 18% in the two years after an acquisition.

Taxation could account for some of these results, according to Mayer. The striking growth in the proportion of cash purchases in the US is associated with a more generous corporate tax treatment of cash than of equity acquisitions. Such provisions do not exist in the UK. In addition, cash receipts are subject to capital gains tax and equity exchanges are not, so offers in cash must be more generous.

But taxation could not provide a complete explanation. For example, the differences in bid premia between cash-financed and equity-financed acquisitions existed before capital gains taxes were introduced in the UK (1965). Furthermore, other research demonstrated that corporate tax incentives were not closely associated with the observed pattern of corporate financing in the UK. In any event, Mayer observed, there was no tax theory that could account for the systematic losses sustained by shareholders in the two years after equity-financed acquisitions in the US.

Mayer suggested a much simpler explanation of the results: the choice of takeover finance was influenced by the mispricing of securities, which in turn reflected differences in the information available to market participants. If the stock market periodically over- and undervalues firms, then managers will offer their firm's shares in periods when managers know these shares are overvalued. An announcement of an equity acquisition may therefore reveal an overvaluation: this signals the market to revise downwards its valuation of the acquiring firm, and the total wealth gains associated with equity acquisitions are therefore less than those of cash-financed acquisitions. The lower bid premia observed in equity acquisitions reflect some acknowledgement by investors of the existence of mispricing, and the losses sustained after equity- financed acquisitions reflect an appropriate reassessment of the value of the acquiring firm. Mayer concluded that, if correct, this hypothesis suggests that the market prices equities inefficiently and that this mispricing has real effects on the allocation of resources through the takeover process.

The question of the longer-run performance of acquisitions was raised in the discussion which followed Mayer's talk. Was it sufficient to study the performance of acquisitions over only two years, as Mayer had done? He agreed that studies over longer periods would be desirable: the difficulty lay in controlling for the other factors affecting share prices in order to identify "abnormal" movements. Studies of acquisitions in the 1970s had covered longer periods but had relied on accounting data instead of share prices to judge performance. On the other hand, it was asked, if the market does misprice securities, should market prices be used to judge the performance of acquisitions? Mayer believed that the evidence of mispricing was not strong enough to justify a return to the accounting data approach of earlier studies.