Overall, stock returns to acquirers tend to be negative or insignificant—in contrast to target companies, where stockholders can benefit greatly.
Companies that believe they may be targets can influence the value of an ultimate acquisition through the design of defensive techniques and by how they react to bids when they occur. Similarly, acquirers can influence the target share prices through their actions prior to the bid.
Most acquirers are overconfident in their ability to conduct acquisitions successfully.
Careful planning, including a robust internal and external communications plan, is required to mitigate the impact on equity markets of acquirers.
Many factors influence equity market reactions to an M&A bid, including how friendly or hostile the bid is, the financing structure of the bid, the relative size of the two companies, and whether the transaction is a merger or an acquisition.
Deals conducted in the most recent merger wave appear to have taken some of these issues into account and show better relative performance (relative to the market) than deals conducted in the 1980s and 1990s.
It would be nice if the markets were to react consistently in response to the announcement of M&A deals. But they don’t. At least not always. But you can depend on one thing: In the short run, shareholders of target companies benefit more than those of the acquiring company.
It is important to know how to cope with the likely equity market reaction to the announcement of a deal. First of all, you need to understand what those likely reactions will be … and then to work out whether there is anything that can be done to influence the market. Bidders can mitigate the likely negative market reaction to their share price, and targets may be able to provoke even higher bids.
This article discusses public companies only—as these are naturally the only ones with an “equity market reaction.” However, one can properly extrapolate their experience to private companies as well. While most advisers and principals in privately held companies take into account the experience of publicly held companies, the reaction of the equity markets regarding the bidder’s share price is not dependent on whether the target is public or private. Either way, the shareholder value of bidders declines, on average, following the announcement of a large acquisition.
“Most mergers fail. If that’s not a bona fide fact, plenty of smart people think it is. McKinsey & Company says it’s true. Harvard, too. Booz Allen & Hamilton, KPMG, A.T. Kearney—the list goes on. If a deal enriches an acquirer’s shareholders, the statistics say, it is probably an accident.”
New York Times, February 28, 2008
Equity Market Reactions for Targets
Relatively few deals make money for the bidding company’s shareholders. The market rather consistently shows that bidding companies lose money for their shareholders, or at best break even around the time of the announcement of a takeover, whereas target companies attract offer premiums that typically range from 20% to 40%. Stock prices often rise above the offer price if a competing bidder is anticipated.
These returns are relatively consistent in the United States and the United Kingdom, with the data for other countries less clear but indicating similar results. When the bidder and target returns are combined, the overall shareholder wealth effects are typically found to be insignificant over the short term and positive over the longer term.
In the absence of a competing bid, when a takeover is announced the target company’s stock price typically rises to a level below the offer price, but slowly rises to approach the bid price as time approaches the closing date when the final deal is consummated, which for most deals is 3–6 months after the announcement date (Figure 1). This is because there is some risk that the deal will not go through or will be repriced (usually lower) because of negative information that the bidder finds while conducting due diligence on the target (see Due Diligence Requirements in Financial Transactions for a discussion of the best ways to conduct due diligence in M&A deals).
Influencing Target Company Stock Prices
The target company itself can have an influence on the potential price offered in a number of ways:
By having a strong defense in place to protect the company from an unsolicited takeover bid. Such defenses can include so-called poison pills (including under-funded pension plans), shares owned by insiders or in friendly hands, golden and silver parachutes not just for senior management but for a wider group of employees (often called “tin parachutes”), and a history of successfully fending off hostile bidders. Research has shown that these defenses, especially poison pills, do result in higher premiums for target companies.
Most of these defenses are put in place to make it more difficult (that is, expensive), but not impossible, to be purchased. For example, Mellon Bank put in place tin parachutes for all its employees following an unsuccessful hostile bid by the Bank of New York in 1998; when later, in 2006, a friendly deal was proposed and accepted by Mellon Bank, the senior managers and employees were requested to waive their golden, silver, and tin parachute rights in order to put them on an equal footing with the Bank of New York employees, who had no such employment provisions.
By letting the market know that a high threshold premium value will be required for any unsolicited bid before the board of directors will recommend it to the shareholders. Yahoo! used this technique when it successfully fended off an unwelcome bid from Microsoft in early 2008 that had a 62% premium associated with it (a so-called “bear hug” offer, which designates an offer above the typical premium range of 20–40%).
By encouraging competing bids. By opening up the purchase of the company to an auction, the directors admit that the company is for sale and will likely lose its independence, but that they are actively seeking the highest possible price. After Morrisons, the supermarket chain in the United Kingdom, made a formal offer to purchase Safeway for £2.4 billion in January 2003, an auction for Safeway ensued with competing bids from Asda (controlled by Wal-Mart) and J. Sainsbury. There was a feeding frenzy that included Tesco, retail magnate Sir Philip Green, and venture capitalists Kohlberg Kravis Roberts. The price that Morrisons ultimately paid for Safeway was £3.0 billion.
Bidders can also influence the target company’s share price, naturally wanting to keep the price of the target down. The most common technique is to conduct a “street sweep,” whereby the target company’s shares (or a controlling interest in the target) are purchased in a blitzkrieg that gives the market and the target’s management no time to react before the takeover is effectively complete. This is very difficult to conduct in practice, and is most successful when a small number of shareholders control a large percentage of the target’s shares or where the bidder already has a large ownership in the target. Thus, for example, Malcolm Glazer, who for a long time had been holding 28% of the publicly listed football club Manchester United, purchased a similarly sized holding from Cubic Expression in May 2004, and thus in one purchase came to control the club.
Many bidders, when purchasing their toeholds in potential targets, will publicly announce that they have no interest “at this time” in making a bid for the entire company, maintaining that their holding is a financial interest only “because the shares represent an attractive investment.” This was the position declared by Malcolm Glazer in the Manchester United case from the time he first disclosed a 3% ownership in the club in March 2003 up until the time he bought the shares that gave him control in 2005. In his case, the market expected a bid for the entire company, but his public position nevertheless may have lowered the price he ultimately had to pay for that controlling interest.
In all of these situations, it must be noted that proper legal advice must be taken in order not to fall foul of the many regulations and laws that prohibit market manipulation.
Equity Market Reactions for Bidders
The shareholders of acquiring companies are not as fortunate as those of the targets. On average, their shares decline in value around the time the company announces its intention to take over another company. Thus, in the example above, when Morrisons launched its surprise bid for Safeway (at a 30.3% premium to the prior day’s close), its shares declined 14.3%, and when J. Sainsbury entered with its competing bid, its own share price declined on the day by 3.5%. The shareholders of neither bidder benefited, in distinct contrast to Safeway’s shareholders.
Because of the relative consistency over time of stock market movements in response to deal announcements, the market will assume that future deals will do the same, including that only 30-40% of all deals are successful, that mid- and long-term shareholder wealth declines by 10-35%, and that the share prices for acquirers and targets move within certain ranges (on average) around the announcement day. Merger arbitrageurs—whether in hedge funds or investment banks—take large positions knowing that bidders’ share prices tend to drop immediately after a deal announcement and that targets will see share price appreciation. This then becomes a virtuous (or vicious, for the bidder) cycle, where the movement in the share prices is magnified by this arbitrage activity.
In many cases these movements in share price can lead to extreme changes in share ownership. For example, when the Deutsche Börse (the largest stock exchange at the time in mainland Europe) made a bid for the London Stock Exchange in 2004, the Anglo-American arbitrageurs rapidly became the largest group of shareholders, displacing the long-term German shareholders, whose ownership was reduced to only a third. It was these arbitrageurs who forced the Deutsche Börse CEO to drop the bid in March 2005, leading to a 30% price rise in the Deutsche Börse shares as it became less and less likely that the deal would succeed.
As with the Deutsche Börse CEO who didn’t anticipate this change, most managers seem to be oblivious to facts which appear to be obvious to those outside the company. A DLA Piper survey in 2006 showed that 81% of corporate respondents rated their M&A experience as fairly or highly successful, and over 90% of venture capitalists felt the same, yet we know that 60–70% of all deals fail.
Influencing the Stock Price of the Bidder
In most M&A situations, the bidder controls the timing of when the bid is publicized. The notable exception to this is when there is a market leak, but even in these situations the leak either happens early in the negotiations when it is easier to deny to the press that any deal is pending (as the negotiations have not progressed sufficiently far for a deal to be in place) or late enough in the proceedings that an emergency communication plan should already be in place for just such a situation.
The announcement event is therefore not a surprise to the bidder. Through proper planning and the use of external advisers (including investment banks, but also specialist public relations firms), positive spin on the deal can be delivered to the market: Benefits to all stakeholders are emphasized; new markets are announced; product innovations are forecast. Support from clients, suppliers, and even outside parties (such as local government) can be rallied. Potential problems will have been anticipated, and strategies to neutralize these will have been developed and disclosed.
Nevertheless, to paraphrase Robert Burns, “The best laid plans of mice and men / Go oft awry.” In M&A deals, there are ultimately just too many individuals involved and there is just so much that can go wrong that much often does. Therefore, the press turns negative, equity analysts forecast too much dilution of earnings, cash flow declines, and clients, suppliers, employees, and even managers become very worried about their positions—and naturally assume the worst.
Thus the acquirer must have a very robust communications plan at the ready. Not every contingency will be anticipated, but many can be. Most important is to have teams in place to be able to respond quickly to any false rumors and to replace immediately any such gossip with fact. The company needs to stay in control—as best it can—during the entire deal process. The most effective way to do this is to have a continuous stream of positive stories prepared for periodic, if not even daily, release. Constant communication with the staff of both bidder and target can go a long way towards allaying anxiety and even panic.
One must remember that those who can benefit from the flip side will be acting accordingly as well: these include competitors who see opportunities to grab market share and even valued staff, and trading arbitrageurs who have made bets in the market that the share price will fall. These arbitrageurs certainly have been very successful in pushing down the price of acquirers in many deals, as in the above example where the Deutsche Börse was forced to drop its bid for the London Stock Exchange.
Other Factors Affecting Equity Values
The above discussion “averages” the results for many companies. Individual deals and individual companies will show different results and provide different returns over time from these averages, and takeover and defensive tactics will also need to be customized for each situation.
There are also other factors that will impact on the equity markets for both the target and bidder’s share price. When cash is used to finance the deal instead of issuing more shares, the returns to the bidder are usually higher. In countries such as the United States, where tender offers (often hostile) are common, these do better than friendly mergers. The smaller the target is in relation to the acquirer, the more likely it is that the bidder’s share price will not decline relative to the market.
There are also differences in short- and long-term shareholder value effects. This article has looked principally at the short-term effects around the time of deal announcement, but if a longer-term perspective is taken (more than six months), then the negative returns to the bidder are reduced, although still typically remaining negative. Also, one can look at the combined returns when the bidder and target are taken together over the longer term: in this case as noted earlier, history shows that the overall shareholder wealth effects are typically positive.
Despite the doom and gloom of the analyses that have looked at the success of companies that merge or acquire, there is some hope: Several recent studies (from Towers Perrin/Cass Business School, McKinsey, and KPMG) have shown that acquiring companies since 2003 are doing better with their deals. Not much, but at least measurably so. Some of the suggestions we’ve made in this article have been recently more widely adopted by the market. There is more focus on careful deal selection and corporate governance. Post-merger integration is receiving attention even before the deal closes, and sometimes even before announcement. There is hope—and evidence—with some of these recent studies that perhaps equity markets may start to award an equity premium to companies that acquire well.
Making It Happen
The Key Factors
Understand that the premium offered to the target is only one aspect of the deal’s success, and that it is often overshadowed by other factors, especially people issues.
Formulate a plan for addressing surprises. Try to identify all the ways that the deal could fail … and then look for still more ways it could go wrong.
Do not be overconfident in your ability to integrate an acquisition successfully. Prior experience is helpful, but not sufficient. Each deal is different.
Proper legal advice should always be taken.
Plan for a dynamic deal process where changes will need to be made to the acquisition strategy.
Incorporate a robust communications plan into any deal.