Do Takeovers Create Value? New Methods and Evidence

1. Do Takeovers Create Value? New Methods and Evidence Sanjai Bhagat, University of Colorado, Ming Dong, York University David Hirshleifer, Ohio State University, Robert Noah, Cambridge Finance Partners

2. The Question Do takeovers improve target and bidder firm value? Other stakeholders not considered: • Employees • Customers/Suppliers • Bondholders

3. Two important challenges to estimating value effects of takeovers • I: Truncation Dilemma (of Window Length) • Short return window: Since not all bids succeed, return is only a fraction of the value effects of successful takeovers. • Long return window: Can capture full value effects. But, return includes greater noise, and raises questions of benchmark specification.

4. Two important challenges to estimating value effects of takeovers • II: Revelation Bias • Bidder’s return at the time of bid gives a wrong estimate of the market’s valuation of the bidder’s gain from takeover, because • Some bidders deliberately time bid announcement with unrelated negative announcements. Wall Street’s version of Wag the Dog (WSJ 12/18/98). • The form of the offer and the very fact of an offer may convey information about the bidder’s stand-alone value.

5. “It's Wall Street's version of `Wag the Dog.’ ” • “Over the past week, both Mattel and Coca-Cola have announced acquisitions on the same day they also issued warnings about disappointing earnings. ... No one is suggesting that either company unveiled its acquisition solely to divert attention from its problems... But it is also clear that the acquisitions, like the [Iraq] bombings, helped shift attention away from other less favorable developments.'' • WSJ, `Heard on the Street', 12/18/98, p. C1

6. Revelation Examples • Returns to bidding firm shareholders. • Fact of an Offer • Good news • Bidder expects high cash flow. • Bad news • Poor internal investment opportunities. • Bidder management with empire-building propensities. • Cash vs. Exchange Offer • Stock Offer: Bad news, lemons problem with equity issuance • Cash offer: Good news that not issuing equity.

7. Solution to Dilemma of Window Length problem • Probability Scaling Method • Like traditional methods, uses short return window. • Method adjusts return from short window upward to reflect the probability of success of bid.

8. Solution to Dilemma of Window Length and Revelation Bias problems • Intervention Method • Focuses on the returns to the bidder when something happens (while the bid is outstanding) that changes the probability of success of the bidder.

9. What might change the probability of success of a bidder? • Litigation by target firm. • Arrival of other bidders. • Objection by a government regulatory agency (FTC, Dept. of Justice). • Defensive measures by target (poison pill, lock-up provision).

10. Arrival of a second bidder: • Decreases probability of success of the first bidder. • If takeover is in the interest of the first bidder, the first bidder’s stock price declines at the arrival of the second bidder. • If takeover is not in the interest of the first bidder, the first bidder’s stock price rises at the arrival of the second bidder. • Note: Decline/rise in the first bidder’s stock price is not related to the stand-alone value of the first bidder, but only reflects value from the takeover.

11. Findings • Value improvements (as % of combined value) from tender offers in the competing bid subsample: • Intervention Method: Mean of 13.1% (median of 12.4%). • Probability Scaling Method: 14.7% (9.7%). • Conventional combined abnormal returns: 9.0% (7.6%). • Full sample of tender offers: • Bradley-Desai-Kim (1988): Conventional combined abnormal returns: 5.3% (3.7%). • Probability Scaling Method: 7.3% (4.6%).

12. Findings Traditional methods lead to incorrect inferences about economic forces in the takeover market. • We find that friendly offers, equity offers, and diversifying offers are associated with lower combined bidder-target stock returns. • A conventional interpretation would be that the gains from combination • are smaller for firms involved with these types of transactions. • However, our new methods indicate that these effects reflect differences in revelation about stand-alone value of the bidder, not differences in the gains from combination. For example, cash offers on average are associated with higher bidder, target and combined abnormal returns than equity or mixed-payment offers. In contrast, based on the intervention method, cash offers do not create higher value improvements than mixed or equity offers. Hence, apparent superiority of cash offers in creating shareholder value is an illusory consequence of a more negative revelation effect for the bidder for equity or mixed offers than for cash offers.

13. Findings • Conventional combined returns, PSM value improvements, and bidder returns tend to be lower in diversifying acquisitions. IM estimates of value improvements are similar in diversifying and same-industry acquisitions. The relative superiority of same-industry acquisitions with PSM (which does not filter out revelation effects) compared to IM (which does) indicates that same-industry acquisitions are associated with more favorable revelation about the bidder than cross-industry acquisitions. This finding suggests that investors perceive diversifying acquisitions as indicating poor investment opportunities within the bidder's own industry.

14. Findings • Bidder announcement period returns and total value improvements are negatively related to bidder Tobin's Q. This result is quite different from the evidence from earlier samples of Lang, Stulz, and Walkling (1989) and Servaes (1991), • Do bidders overpay? • Conventional combined abnormal returns: Yes. • Intervention and Probability Scaling Methods: No.

15. Specifics of the Intervention Method 4 dates t = 0: Time prior to first bid. t = 1: Arrival of first bid. t = 2: Time prior to arrival of competing bid. t = 3: Arrival of competing bid.

16. y : Market value of bidder not related with takeover. t : Bidder's profit from takeover conditional on t. Pt : Bidder's price at t. Hence, P1 = y + 1 , P3 = y + 3 . (8)

17. V0T : Non-takeover target value.  : Fraction of target held by first bidder prior to first bid. VC : Combined post-takeover value. V0B : Non-takeover bidder value. VI :Value improvement from takeover. Then, VI = VC – V0B – V0T(1- ) (1)

18. V1 , V3 : Post-takeover gains. B1 , B3 : Price ultimately paid by a successful first bidder. Hence, 1 = Pr(S|q1) {aV1 + (1-a)[V1 + V0T - B1]}, 3 = Pr(S|q3) {aV3 + (1-a)[V3 + V0T - B3]}. (9)

19. Assume, V3 = V1 = V . [See footnotes 18, 19, sec. 4.5] Also, R3 = P3 / P1 - 1. (VI/VC) = {[R3(P1/V0)] / [Pr(S|q3) - Pr(S|q1)]} {(1 - a) [l(B1/V0) + (1 - l)(B3/V0) - 1](VOT/ VC)}, (11) where, l = Pr(S|q1) / [Pr(S|q1) - Pr(S|q3)]. LHS of (11) is the Intervention Method Improvement Method, IRIM. Strong Agency / Hubris Hypothesis: IRIM = 0. IRIM> 0. Implies joint value improvement.

20. The Probability Scaling Method of Estimating Value Changes : IRPSM Value Improvement = [Combined Initial Bidder and Target Return] / [(Probability a First Bidder arrives and wins) + (Probability a First Bidder arrives but a Later Bidder wins)] (6)

21. DATA • MERC and SDC datasets. • Table 1: 1018 tender offers during 1962-2001. • Figure 2 : Percentage of • Successful takeovers, • Multiple (two) bidder takeovers, • Hostile takeovers, • All cash offers. • Figures 3, 4 : Mean percentage and dollar shareholder returns to • Bidders, • Targets, • Combined entity, • over various sub-periods during 1962-2001.

24. Table 3, Model B: Entry of second bidder significantly lowers probability of success of first bidder.

25. ESTIMATES OF VALUE IMPROVEMENTS (VI/VC) = {[R3(P1/V0)] / [Pr(S|q3) - Pr(S|q1)]} {(1 - a) [l(B1/V0) + (1 - l)(B3/V0) - 1](VOT/ VC)}, (11) where, l = Pr(S|q1) / [Pr(S|q1) - Pr(S|q3)]. LHS of (11) is the Intervention Method Improvement Method, IRIM. R3 : Bidder abnormal return at entry of second bidder = -.43%. P1/V0 : Size of bidder relative to initial combined value = .656 (median = .690).

26. Pr(S|1) : Unconditional probability of success of first bidder = 690/1018 =.6778. Pr(S|3) : Probability of success of first bidder given arrival of competing bid = 38/147 =.2585.  : Fraction of target's equity owned by first bidder = .024 (median = .000). B1/V0 : Average price at which first bidder wins in full sample = 1.407 (1.384). B3/V0 : Average price at which first bidder wins given arrival of competing bid = 1.514 (1.421).

27. Table 4 IRIM : Implicit market estimates of the value improvement as a result of the takeover. CIBR: Combined Initial Bid Return = target CAR* (target market value/target and bidder market values) + bidder CAR * (bidder market value/target and bidder market values). CAR is the market-model cumulative abnormal return for the target or bidder over the period five days before the first bid through five days after. IRPSM : (CIBR)/(Probability the first bidder succeeds unconditionally + Probability a later bidder succeeds). All improvement ratios are expressed as a percent of target and bidder market values.

31. Table 5, Panel B; Table 6, Panel B IRPSM - IRIM (Estimated Revelation Bias)

33. SENSITIVITY ANALYSIS 1. Sensitivity of mean of estimated IRIM to simultaneous variation in each of the estimated parameters [Pr(S|1), Pr(S|3), B1/V0 , B3/V0] in the direction of lower IRIM: Mean IRIM remains positive with simultaneous 12% shift in all four estimated parameters. 2. Parameter estimates from Bhagat-Shleifer-Vishny (1990): IRIM = 9.0% (9.9%). Parameter estimates from Betton-Eckbo (2000): IRIM = 17.5% (15.3%).

34. SENSITIVITY ANALYSIS • 3. Model Specification: Table 10 • If the arrival of a competing bid causes an upward revision in the expected post-takeover value of the target to the first bidder => K > 1. • If the first bidder fails to acquire the target, the first bidder will successfully acquire another similar target at a similar premium=> g > 0. • An unsuccessful first bidder can sometimes profit by selling its holdings to a successful competing bidder=> Pr(S2|q3) > 0.