The question for many finance managers and even smaller investors is what impact is felt when one firm acquires another. The topic has been analyzed to death in recent decades as the 1980s began a new era in the world of corporate finance with a much larger number of companies participating in mergers, acquisitions and sometimes hostile takeovers. The question then for financial planners was what impact the proposed acquisition would have on the acquiring firms.

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There is something of a consensus of opinion that many acquired firms go through a huge reorganization after being taken over, either voluntarily or involuntarily, and end up, generally, as more profitable entity, either by eliminating mismanagement, divestiture of unprofitable divisions, or simply the streamlining that comes from having new management take a look at “the way things have always been done.”

In contrast, there is a continuing debate about the effect that acquisitions have on the acquiring firm. Some argue that the acquisition increases profitability of the acquiring firm. Others argue that the turmoil created by an acquisition results in a short term decrease in profitability for the acquiring firm.  Still others argue about how the value of the acquiring firm is being calculated including the effects of long-term debt from the cost of acquisition (if there is a debt), if stock price should be a determining factor and if profit margins should be included in the dynamic.  It is probably safest to claim that short-term, acquisitions create an instability in stock prices and in an investor’s return on investment that can be hazardous if the firm is on shaky ground, but in the long term, most acquiring firms reap benefits in total corporation value and profitability via acquisitions.

In the article “Wealth Destruction on a Massive Scale?”, the authors discuss the difference in the wealth impact of mergers in the 1990s versus those in the 1980s and attempt to delineate the causes thereof. Having identified the decade as having overall larger losses of wealth, the paper then sets out to show the mechanisms which defined the loss (Moeller,

Page 2 Mergers and Acquisitions: What happens to Acquiring Firms? Essay

et al. 2005). Centering their evaluation on the three days surrounding the announcement of the merger, the authors looks at the companies with the largest overall losses, including 87 whose losses exceeded $1 billion. The study then further narrows the coverage period to the years from 1998 to 2001 when the greatest number of large losses were observed and attempts to analyze what factors caused the large losses and what might be indicators of similar losses in the future (Moeller, et al. 2005).

When the study is controlled to eliminate these large loss firms, the information indicates that the performance surrounding merger announcements is generally positive leading the researchers to posit that investors must have determined as a result of the merger that these firms were overvalued in the first place. The authors argue that since these are serial acquirers, it is probable that the market determined growth via acquisition was no longer a viable option in each of these cases (Moeller, et al. 2005).

They further observe that though these large loss firms skew the entire study with their results, their significance is worthy of noticing simply because of their size. In essence, they argue that although these companies reflect a relatively small segment of the mergers, the dollar value of these mergers makes them significant. Furthermore, they argue that the trend is clear that investors are identifying mergers which are taking place to solely to promote growth of revenue via growth of investment and are wise enough to understand that total revenue growth is not the same as actual growth. Therefore, the investors understandably devalue the companies which cannot see the difference.

Clearly, based on this study, there is some evidence that acquiring firms saw an immediate loss in value when acquiring other firms which were viewed as underperforming.

“Acquiring-firm shareholders lost 12 cents around acquisition announcements per dollar spent on acquisitions for a total loss of $240 billion from 1998 through 2001, whereas they lost $7 billion in all of the 1980s, or 1.6 cents per dollar spent. The 1998 to 2001 aggregate dollar loss of acquiring-firm shareholders is so large because of a small number of acquisitions with negative synergy gains by firms with extremely high valuations. Without these acquisitions, the wealth of acquiring-firm shareholders would have increased. Firms that make these acquisitions with large dollar losses perform poorly afterward.” (Moeller, et al. 2005).

However, later studies have argued that the conclusions reached by Moeller and her co-authors is short sighted and does not take into effect the long-term rebounding capabilities of the acquiring firms.  The article “Industry prospects and acquirers’ returns in diversifying takeovers” attempts to identify the impact that negative information about an industry released during an acquisition announcement has on the overall decline in the valuation of the acquiring company and its most homogenous rivals (Shahrur and Venkateswaran 2006). The premise is simple and makes logical sense, but the process of proving it was a bit more difficult.

The idea is that when a company announces it is acquiring another, it often does so because there is a previously unrevealed issue with its primary business operation. That problem (or perceived problem) is then revealed by the decision to acquire an unrelated business (at least for the purposed of this study). The first proof that the authors offer of their hypothesis is a multi-variant analysis of the acquisition announcement on the pricing of the acquiring firm and its most homogenous rivals. The evidence indicates that even when there is no actual negative growth in the companies’ main business, the firms suffer negative CAR indicative of a market squeamishness brought on by the acquisition announcement (Shahrur and Venkateswaran 2006).

After careful analyses of other factors which may also account for the negative wealth growth associate with this phenomena, the authors determine that acquisition announcements are generally viewed as offering negative information about the industry’s future prospects and that this results in negative wealth growth for the acquirer and its most direct rivals (Shahrur and Venkateswaran 2006).. The significance of this study in terms of mergers and acquisitions is for financial managers to anticipate this “future prospects” impact and manage industry information with regard to the future prospects in conjunction with the acquisition announcement.

For example, if the company’s main industry is  selling washing machines and it is acquiring a bank, then emphasizing the positive correlations between the new acquisition and the main industry, i.e. “We can now offer in-store financing”,  is imperative to positive wealth growth of the company. Companies considering merger or acquisition announcements may also wish to time their announcements around other positive announcements regarding their main industry in an attempt to head off these issues.

“We suggest that the poor abnormal returns to acquiring firms’ shareholders in diversifying takeovers are in part due to negative informational releases regarding the acquirer’s main industry. In a sample of 816 diversifying takeovers, we test this hypothesis by analyzing the effects of takeover announcements on the rivals of the acquiring firm. We focus our analysis on homogenous rivals, which are rivals that are more likely to be affects by the same economic shock that may result in the acquirer’s decision to diversify. We identify homogenous rivals by using pre-takeover correlations in the stock returns of the acquirer and each rival firm.

We find that homogenous rivals experience statistically and economically significant negative abnormal returns at the takeover announcement. We also find that the revisions in analysts’ forecasts of homogenous rivals’ earnings per share are significantly negative around the takeover announcements. Taken as a whole, our results imply that a large part of the acquirer adverse price effect at the announcement of diversifying takeovers is due to negative informational releases about its principal industry. Thus, previous estimates of takeover wealth effects that use announcement period abnormal returns are likely to be biased downward.” (Shahrur and Venkateswaran 2006).

The discussion then is whether the publicity surrounding acquisitions has a negative effect on stock prices and perceived value of the firm, resulting in a loss of actual value. To think of it in less philosophical terms, imagine this situation; Joe’s Lemonade stand decides to acquire Susie’s Lemonade and Stuff. In the process of the acquisition, Joe’s management announces that the acquisition of Susie’s will allow the expansion into new markets. But speculation runs high that Susie’s is a poorly-run organization with significantly lower profitability than Joe’s. Even Joe’s stockholders are then questioning whether the new markets, formerly held by Susie’s are competitive and will result in the same level of profits they have previously enjoyed.

According to this study, the impact of the supposition that Susie’s is not making money (why else would you sell it?) is greatest when the acquired and acquiring firms are in the same industry. When there is a perceived added value in the acquisition, i.e. a car manufacturer acquiring a credit union allowing them to make personal loans for their cars, the impact of the acquisition on the total value of the acquiring firm is lessened, but still exists (Shahrur and Venkateswaran 2006).

Another question impacting the effect of the acquisition on the acquiring firm can be the amount paid for the acquisition and whether investors view it as a good deal. Take, for instance, the recently announced attempt by Microsoft Corporation to acquire Yahoo!.

“On February 1, 2008 Microsoft announced that it had made a proposal to the Yahoo! Board of Directors to acquire Yahoo! for $31 per share in cash and stock, representing a total equity value of approximately $44.6 billion (based on share prices as of January 31, 2008). Microsoft’s proposal, which represents a 62 percent premium above Yahoo!’s closing stock price on January 31, 2008, would create a more competitive company while providing superior value to shareholders and better choice and innovation for customers and partners.” (Microsofte Press Release 2008).

Financial analyst Jack Schofield argued that the immediate plunge in Microsoft’s stock value was directly related to the proposed acquisition. “It seems that shareholders don’t think a Yahoo takeover is a good idea. Even though Microsoft just reported some outstanding financial results, its share price is taking a beating. As has been pointed out, this reduces the value of the bid, which is half cash-half shares.” (Schofield 2008). But others point out the drop coincided with other stock market losses and may reflect a greater uncertainty in the market as a whole rather than a specific problem related to the takeover attempt.

Whether the Microsoft bid proves to result in a long-term loss in profitability for the computer giant is anybody’s guess, but it does appear that on a very simplistic overview, acquiring firms see a sometimes significant loss in value during the first months after an acquisition and sometimes in the months leading up to the acquisition. On the other hand, the evidence seems fairly clear that the long-term result is increased profitability for the acquiring firm as demonstrated by the staggering increase in stock values in the late 1980s and 1990s.

The question then for the financial manager and the individual investor is one of immediate value and long-term return. If the issue is immediate value, investors would be wise to steer clear of firms that are accelerating their growth via acquisitions. However, if the investment is intended for long-term profitability, the small glitches in value that occur immediately after an acquiring firm makes its acquisition announcement and immediately following the acquisition are little more than bumps in the road to a healthy financial future.

Works Cited

Berger, P. G. Ofek. E., 1995. Diversification’s effect on firm value. Journal of Financial Economics 37, 39-65.

Brous, P., Kini, O., 1993. A reexamination of analysts’ earnings forecasts for takeover targets. Journal of Financial Economic 33, 201-225.

Comment, R., Schwert, G. W., 1995. Poison or placebo? Evidence on the deterrence and wealth effects of modern antitakover measures. Journal of Financial Economics 39, 3-43

Eckbo, E. B., 1983. Horizontal takeovers, collusion, and stockholder wealth. Journal of Financial Economics 11, 241-273.

Eckbo, E. B., 1985. Takeovers and the market concentration doctrine: Evidence from the capital market. Journal of Business 58, 325-349.

Microsoft press release, February 1, 2008, Available at: http://www.microsoft.com/presspass/press/2008/feb08/02-01CorpNewsPR.mspx, Accessed: April 23, 2008.

MOELLER, SARA B., FREDERIK P SCHLINGEMANN, RENÉ M STULZ (2005) Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave “, The Journal of Finance 60 (2) , 757–782.

Schofield, Jack. “Microsoft share price plunges following Yahoo takeover bid”, February 7, 2008. Available at: http://blogs.guardian.co.uk/technology/2008/02/07/microsoft_share_price_plunges_following_yahoo_takeover_bid.html, Accessed: April 23, 2008.

Shahrur, Husayn and Venkateswaran, Anand. “Industry prospects and acquirer’s returns in diversifying takeovers,” presented at the 2006 EFMA meetings in Madrid and the 2005 Financial Management Association Meeting. Anand Venkateswaran.

Tuch, Christian and Noel O’Sullivan (2007) The impact of acquisitions on firm performance: A review of the evidence,” International Journal of Management Reviews 9 (2) , 141–170.

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