An Examination of the Long-Run Performance of UK Acquiring Firms - Case Study Example

Critically evaluate the methodological issues and empirical findings of the following paper: An examination of the long run performance of UK acquiring firms Whenever, there is an acquisition there are bound to be changes and repercussions on this action. The following article examines the impact of the gains to shareholders of firms that announce acquisitions of public firms, private firms, or subsidiaries of other firms. Acquisitions are substantial investments made by a firm. When a firm announces an acquisition, the wealth of acquiring-firm shareholders substantially increases, but however, the average dollar change in the wealth of the acquiring-firm’s shareholders when such acquisition announcements are made is negative when the firm doing the acquiring is a large firm. It’s been noted that the acquisitions made by small firms are profitable for their shareholders. Small firms make small acquisitions and this gives them small dollar gains. A large firm will make a large acquisition and this will result in large dollar losses. So, such acquisitions result in losses for shareholders it is because the losses incurred by a large firm are much higher than the gains realized by a small firm during acquisition. A sample study of some firms in the U.K and the profitability for small firms which do acquisitions is shown the Table1. The above table summarizes take-overs in the U.K ,by firms which were considered during a sample study. It shows a majority of acquirers are concentrated in the top two deciles according to market capitalization. A total of 157 out of the 398 acquirers for market capitalization are available in the top decile. This table shows that the firms which are acquiring are smaller companies and such acquisitions are seen to be profitable for them. There are a number of explanations given as to why the size-effect occurs, meaning, why acquisitions made by small firms are profitable for their shareholders as compared to acquisitions made by large firms. Following are some explanations given for this size effect: The managers of large firms have an oversight and so pay more for their acquisitions and this results in losses during acquisitions. Large firms which suffer from poor returns pay out for acquisitions, with their equity and this results in loss for shareholders. Large firms make acquisitions when they do not have any more internal opportunities for growth and this results in losses when the firm makes an acquisition. Large firms which are interested in empire building would rather make acquisitions, than increase their payouts to shareholders. There is a price pressure effect on the stock price of the bidder, when a firm’s acquisitions are paid for from its equity, due to the activities of arbitrageurs. The incentives of managers in small firms are better aligned with their shareholders than is the case in large firms and that’s why their acquisitions are more profitable, when compared to that of large firms, which are not interested in increasing payouts to their shareholders. Evidence of the size-effect is shown in acquisitions made by firms in the U.S. and the U.K. In both these countries takeovers have been made by large organizations, in recent years and this has produced significant negative returns for their shareholders. A study of this trends has been done using models, to find out if these acquisitions really led to negative abnormal returns, or whether these results were caused by some type of specification error. In order to do this study various benchmarks were used. These Benchmarks or models have been listed below: Type of Models Model One: CAPM: This model describes the relationship between risk and expected return. It is used in the pricing of risky securities. This is calculated as follows:   The general idea behind CAPM is that investors need to be compensated both in terms of money and the risk taken by them in investment. Model 2: Dimson-Marsh risk and size adjusted model (DM). This model is calculated as follows: In this model, the control portfolios are equally weighted average returns on a portfolio of all firms in the decile to which firm i belongs. Decile betas are calculated based on the OLS regression of decile excess returns on market excess returns for the 36 months following completion of the takeover. Model 3: Simple size control portfolio (SS): This is calculated as follows: Model 4: Multi-index model using equally-weighted smaller decile minus large decile returns (SML). This is calculated as follows: Here, ‘R610t’, stands for return on an equally weighted portfolio of smaller (deciles 6 to 10) companies in event month t and ‘R1t’, stands for the return on an equally weighted portfolio of largest (decile 1) companies in event month t. Model 5: Value weighted multi-index model using the Hoare-Govett Index as the measure of smaller company performance: This is calculated as follows: Here, ‘Rht’, stands for the return on the Hoare-Govett Smaller Companies index in event month t. The motivation for using the Hoare-Govett Smaller Companies Index (HGSCI) is that this is a value-weighted index of the bottom 80% of companies by market capitalization; this model has also been used in the analysis of UK unit trust performance. Model 6: This is the Fama and French value-weighted three factor model. This is calculated as follows: Here, SMB stands for the value-weighted return on small firms minus the value- weighted return on large firms and HML stands for the value-weighted return on high BMV firms minus the value-weighted return on low BMV firms. This model punishes stocks classified as small-cap or value, in other words, stock which have a high book value to market value. Fama and French supported the Efficient Market Hypothesis and they felt that more returns come only by taking on extra risk. So, when small-caps or value stocks have a higher than average return, it indicates that they are riskier. The biggest problem faced by this models is that Fama and French don't specifically state why the size of a company or it's book-to-market ratio is a proper indicator of risk. On the whole, it been noted that none of these models are free from problems. Out of them the model showing the least problems would be Model 5. Model 1 shows a disadvantage because it makes no allowance is made for firm size effects. Thus using the market model can result in a negative bias in the post-acquisition CARs. In Model 2 and Model 3, the disadvantage is that both of them define decile membership, based on the beginning of the year. In case the takeovers is over 10 million, there will be new equity financing and this will cause an increase in capitalization. Such an increase for companies in lower deciles will cause them to be promoted by more than one decile , especially in the case of smaller companies. However, decile changes only take place at the beginning of every year so that if takeovers are assumed to occur uniformly throughout calendar years on average, the decile membership group can potentially be incorrect for the six months following a takeover. Model 3 shows the disadvantage of using decile betas and firm betas, which are identical. Models 4 and 5 use a form of post-event extended CAPM, which show that beta risks and firm size are significant in explaining the cross-section of expected returns. In the above figure what is observed is that all six models are consistent. None of the models display significant abnormal returns for the month of announcement. The table shows the CAARs and APIs, along with the appropriate t-test statistics. The CAARs and APIs are calculated for periods t0 to tc+24 where t0 is the month of announcement and tc is the month of completion of the takeover. For the announcement period (defined as from the month of announcement up to and including month of completion),17 the multi-index SML Model 4 and the Fama-French three-factor Model 6 produce significant negative APIs and CAARs. All models show significant negative APIs and CAARs for the 24 months following completion of takeover. Thus the message from all these event-study models is clear; the long-run shareholder wealth effects of recent acquisitions in the UK have been, on average, significantly negative. However, the various models do lead to economically significant differences in the magnitude of the negative abnormal returns. Conclusion Through the various models employed for the study of acquisitions, it has been found that small firms do much better than large firms, when they make an acquisition announcement. It been seen that the abnormal return associated with acquisition announcements for small firms exceeds, the abnormal return associated with acquisition announcements of large firms by 2.24 percentage. When a small firm makes an acquisition of a public firm, with equity they gain significantly when they announce the acquisition. Large firms experience a loss in the wealth of its shareholders, when they announce acquisitions of public firms, and this does not depend on how the acquisition is financed. This trend was found present in the United States, throughout the 1980s as well as in the 1990s and across sub samples of acquisitions and in regressions that control the firm and deal characteristics. Large firms offer larger acquisition premiums than small firms and enter acquisitions with negative dollar synergy gains. The evidence shows that managerial hubris plays a chief role in the decisions of large firms. Managers of large firms, tend to be overconfident, owing to the fact that they work for such a large company. They may have spent a lot of time in working to make the firm a large one, and this results in them not having the kind of instincts, which are found in managers of small firms. They would have left some options, which would have been considered by the managers of small firms, when making acquisition decisions and this is why they spend a lot of money during the acquisition. In the end the managers of large firms, they land up paying more during an acquisition. When they pay more during an acquisition, they If a firm pays too much, they are just redistributing wealth from the shareholders of their firm to the shareholders of the acquired firm. This makes acquisitions made by large firms something, which is not profitable for their shareholders. There is no evidence that this size-effect will change over time. Large firms are seen to offer larger acquisition premiums than small firms and enter acquisitions with negative dollar synergy gains. The evidence is therefore consistent with managerial hubris playing more of a role in the decisions of large firms. 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