The Art of Capital Restructuring: Creating Shareholder Value through Mergers and Acquisitions

CHAPTER 1

Mergers, Acquisitions, and Corporate Restructuring: An Overview

H. KENT BAKER

University Professor of Finance and Kogod Research Professor, American University

HALIL KIYMAZ

Bank of America Chair and Professor of Finance, Rollins College

INTRODUCTION

An important question in finance is whether managerial actions create market value or shareholder wealth. Neoclassical economic theory assumes that corporate management acts to maximize shareholder wealth. Studies involving mergers and acquisitions (M&As) directly examine this issue. Such studies, which are relevant to shareholders, managers, regulators, and other stakeholders, show considerable variation in their results. Thus, debate continues about both the short-term and long-term performance of M&As. As markets become more integrated, M&As continue to be a hot topic in both academia and the business world. Given the frequency of these activities, businesspeople need to understand why and how such activities take place.

Although sometimes used interchangeably or synonymously, the terms merger and acquisition mean slightly different things. A merger is a combination of two or more companies in which one company survives and the merged company goes out of existence. Unlike a merger, a consolidation is a business combination in which two or more companies join to form an entirely new firm. With an acquisition, one company takes controlling ownership interest in another firm, typically buying the selected assets or shares of the target company. On the surface, the distinction in meaning may not seem to matter because all of them are strategic transactions that usually change not only the control of a company but also its strategic direction. Depending on the transaction, the financial, legal, tax, and even cultural impact of a deal may differ substantially.

M&As represent a fast-paced and highly complex environment in which transactions provide unique opportunities with considerable risk. Worldwide M&A transactions involve trillions of dollars that can have a major impact on both domestic and global economies. M&As are a vital part of any healthy economy because they force firms to use their resources efficiently and allow strong companies to grow and weaker companies to be swallowed. Further, M&As enable firms to achieve or maintain their competitive advantage by anticipating and adjusting to change. Through M&As a company can grow rapidly without having to create another business entity. Consequently, M&As represent a vital business tool and an alternative growth and expansion strategy for many companies. In short, an M&A is an instrument of macroeconomic renewal. Yet, these complex transactions are laden with potential problems and pitfalls. In fact, many M&A transactions fail to realize expected benefits. Understanding how to ensure the successful consummation of these transactions is critical to the goal of maximizing shareholder wealth.

PURPOSE OF THE BOOK

This book provides a fresh look at the current state of mergers, acquisitions, and corporate restructuring in both developed and emerging markets. Although M&As generally focus on corporate expansion, companies sometimes contract and downsize their operations. Restructuring refers to the act of partially dismantling or otherwise reorganizing a company for the purpose of making it more profitable. This book considers several different forms of physical restructuring such as divestitures as well as capital restructuring, which refers to alterations in the capital structure of the firm. This volume explains not only the financial aspects of these transactions but also legal, regulatory, tax, ethical, social, and behavioral considerations. In short, although economics plays an essential role in understanding M&A activity, psychology also plays a critical part. Thus, achieving success in any M&A effort is a combination of both art and science.

Additionally, the latest research on M&A-related topics permeates the book. The coverage extends from discussing basic concepts, motives, strategies, and valuation techniques to their application to increasingly complex and real-world situations. The book explains these methods from both a management and investor perspective while emphasizing the wealth effects on shareholders of these different strategies. Thus, this volume spans the gamut from theoretical to practical, while attempting to offer a useful balance of detailed and user-friendly coverage.

DISTINGUISHING FEATURES OF THE BOOK

Given the popularity and importance of mergers, acquisitions, divestitures, and other financial capital restructuring, the fact that many books deal with these topics is not surprising. Yet, most do not offer the scope of coverage and breadth of viewpoints contained in this volume. The book provides a comprehensive and current discussion of theoretical developments, empirical results, and practice involving M&As. Where possible, this volume avoids theoretical and mathematical derivations unless they are necessary to explain the topic. It attempts to distill the results of several hundred empirical studies in an understandable and clear manner.

The book has seven other distinguishing features.

1. The book attempts to blend the conceptual world of scholars with the pragmatic view of practitioners. This volume is not a how to book or a simple easy-to-use-guide but instead incorporates theory and practice. It also provides a synthesis of important and relevant research studies in a straightforward and pragmatic manner and includes recent developments.

2. The book contains contributions from more than 40 scholars and practitioners from around the world who are leading experts in their fields. Thus, the breadth of contributors ensures a variety of perspectives and a rich interplay of ideas.

3. This book emphasizes best practices that lead to M&A success. Such practices focus on valuing the target, negotiating and financing the deal, and engaging in postacquisition planning and integration.

4. The book offers a strategic focus to help provide an understanding of how these decisions can affect overall value. These strategies include both takeover and defensive strategies.

5. The book has a global focus rather than being U.S.-centric. It reviews research dealing with both U.S. firms and others from around the world. Special emphasis is placed on the cross-border effects involving developed and emerging markets.

6. The book examines both technical and human aspects of M&As. The technical aspects mainly deal with legal, regulatory, and valuation issues. By contrast, the human aspects deal with issues involving corporate governance, cultural due diligence, organization and human resources, and the behavioral effects.

7. Each chapter contains a set of discussion questions that helps to reinforce key aspects of the chapter's content. A separate section near the end of the book contains guideline answers to each question.

INTENDED AUDIENCE FOR THE BOOK

The intended audience for this book includes academics, researchers, practitioners (e.g., business executives, managers, investment bankers, lawyers, and consultants), students, libraries, and others interested in mergers, acquisitions, and restructuring. Given its extensive coverage and focus on the theoretical and empirical literature, this book should be appealing to academics and researchers as a valuable resource. Practitioners can use this book to provide guidance in helping them navigate through these strategic transactions. This book should be appropriate as a stand-alone or supplementary book for advanced undergraduate and graduate business students as well as for management training programs in M&As. Finally, libraries should find this work to be suitable for reference purposes.

STRUCTURE OF THE BOOK

The remainder of this book consists of 28 chapters divided into six main parts. A brief synopsis of each part and chapter follows.

Part I. Background

This part contains six chapters (Chapters 2–7) that provide important background information that sets the stage for the remaining sections. The first three chapters focus on merger waves, takeover regulation, and corporate governance. Next, Chapters 5 and 6 examine ethical, social, and theoretical issues involving M&As. Chapter 7 focuses on the short-term and long-term performance of M&As.

Chapter 2 Merger Waves (Jarrad Harford)

The chapter surveys the vast literature on mergers with a focus on merger waves. The motives for mergers run the spectrum from a purely efficient reshuffling of assets to purely managerial driven empire-building strategies. Because merger activity clusters in time and within industries, an understanding of the causes of these merger waves is needed to comprehend the dominant motivations behind mergers. Research clearly establishes a link between aggregate economic activity, especially as reflected in the stock market, and aggregate merger activity. Further, research shows that technological, regulatory, and economic shocks to industries’ operating environment, coupled with macro-level ease of financing, generate merger waves. While the primary driver of merger activity is economic efficiencies, room exists for other motives such as empire building. Nonetheless, the other motives do not dominate the activity.

Chapter 3 Takeover Regulation (Marina Martynova and Luc Renneboog)

Takeover regulation is a set of legal provisions aimed at facilitating efficient corporate restructuring, mitigating potential conflicts of interest among parties involved in the control change transaction, and protecting minority shareholders. This chapter reviews the major takeover regulation provisions present in different jurisdictions around the world that include the mandatory bid rule, principle of equal treatment of shareholders, squeeze-out and sell-out rules, ownership and control disclosure, board neutrality concerning the takeover bid, and restrictions regarding the use of takeover defense measures. The chapter shows that takeover regulation provisions vary substantially across jurisdictions, reflecting different priorities as to the goals regulators set relating to the development of the takeover market and corporate governance.

Chapter 4 Corporate Governance and M&As (Fei Xie)

This chapter surveys the body of research at the intersection of two broad literatures, corporate governance and M&As. Four major themes and findings emerge. First, M&As as a managerial disciplinary device and part of a comprehensive corporate governance system have powerful incentive effects on managers and valuation effects on shareholders and bondholders. Second, as major corporate investments, M&As generate higher returns for acquiring shareholders when acquiring managers operate in environments of better corporate governance. These environments are defined by exposure to threats of hostile takeovers, competition from the product market, effective monitoring by boards and institutional investors, a strong link between managerial wealth and performance, and the risk of financial distress and ceding control to creditors. Third, the target firm's corporate governance is also important as target shareholder gains are significantly higher when the interests of target managers and shareholders are better aligned. Lastly, as a mechanism to allocate resources to their most efficient use, M&As generate synergistic gains and efficiency improvement that increase with the difference in corporate governance between acquiring and target firms.

Chapter 5 Ethical and Social Issues in M&As (Robert W. McGee)

The press, politicians, policy makers, and some economists often view M&As negatively, as something that must either be stopped or heavily regulated. Some perceive that workers are harmed by M&As, which is sometimes the case, while others view M&As as anticompetitive, which is often not the case. From a philosophical perspective, one might raise the question of whether such activity should be regulated at all if M&As do not violate anyone's rights. Yet, this question is seldom raised. This chapter examines some ethical issues that have been raised and applies several tools of ethical analysis in an attempt to determine which acts are ethical and which are not.

Chapter 6 Theoretical Issues on Mergers, Acquisitions, and Divestitures (Abdul H. Rahman)

Value-increasing motives for corporate takeovers may be categorized as creating operational efficiencies or allocative synergies, which can create market power. Empirical findings suggest that the former category dominates managers’ motives. Value-decreasing motives are based on managers’ private interests such as reduction of employment risk, managerial discretion driven by excess free cash flow, and managers’ overconfidence or hubris. Evidence suggests that M&As occur in waves and across industries. The level of merger activity is also positively correlated with bull stock markets. Several models, including those based on chief executive officer envy and firm size, offer explanations for this evidence. Divestitures may be viewed as managerial actions to reverse or correct previous strategic decisions such as diversification, or to establish strategic positioning. As such, while takeovers expand the boundary of the firm, divestitures do the opposite. Sources of divestiture gains include the focus hypothesis where managers attempt to eliminate business units in different industries. Divestment may also reduce information asymmetry and hence lead to a more optimal pricing mechanism for both the parent firm and the spin-off business unit. Finally, divestiture gains may arise from negative synergies when the firm is overdiversified.

Chapter 7 The Short-Term and Long-Term Performance of M&As (Shantanu Dutta and Samir Saadi)

This chapter focuses on short-term stock return performance of target and acquiring firms and long-term stock return and operating performance of acquiring firms. Evidence shows that target shareholders generally earn significantly positive abnormal returns but the acquirers’ shareholders earn, on average, a zero abnormal return at the acquisition's announcement. Considerable variation exists in these results. However, various studies with non-U.S. data consistently report significant and positive abnormal returns for acquirers’ shareholders around the announcement date. A set of other studies investigates the long-term stock return performance of acquiring firms. Most of these long-term studies conclude that acquiring firms experience significant negative abnormal returns over a one- to three-year period after the merger. Still, debate continues on this issue. Given a lack of consensus on market-based studies and counterintuitive results, a smaller but growing body of literature investigates the long-term operating performance of acquiring firms. Previous empirical studies in this area report mixed and inconsistent results.

Part II. Valuation

This part consists of four chapters (Chapters 8–11) dealing with valuation methods. Chapters 8 and 9 examine standard valuation methods and real options, respectively. Chapter 10 examines the adjustment needed for the implicit minority discount. Chapter 11 focuses on cross-border valuation effects in developed and emerging markets.

Chapter 8 Standard Valuation Methods for M&As (Pablo Fernandez)

This chapter describes the four main groups comprising the most widely used company valuation methods: (1) balance sheet–based methods, (2) income statement–based methods or multiples, (3) discounted cash flow methods, and (4) value creation methods using economic value added and economic profit. Conceptually correct methods are based on cash flow discounting. The chapter briefly discusses other methods that are conceptually incorrect but continue to be used in practice. The chapter also addresses the lack of agreement about ways of calculating the value of tax shields and the dispersion of the market risk premium used by professors and financial analysts.

Chapter 9 Real Options and Their Impact on M&As (Hemantha Herath and John S. Jahera Jr.)

The use of option analysis has grown from use with financial options to the application to real options. One specific application involves the M&A process. Almost all such transactions have embedded options that can address issues ranging from the specific terms of the M&A to the timing of the M&A decision and perhaps even the later divestiture decision. The impact of real options on M&A analysis is still developing as more managers acquire the knowledge to specifically value different decisions involved in a transaction. Traditional M&A analysis followed capital budgeting techniques such as net present value. Financial economists argue that such techniques are unable to capture value associated with managerial flexibility and other elements. As M&A activity has become more global, managers not only face greater complexity but also more alternative courses of action. Real options analysis represents another dimension to be incorporated into the decision to engage in M&A activity.

Chapter 10 The Law and Finance of Control Premia and Minority Discounts (Helen Bowers)

The adjustment for the implicit minority discount is a controversial element of Delaware court practice. The Delaware courts usually adjust the value of minority shares in appraisal action upward to reflect a perceived market inefficiency that results in a persistent undervaluation of equity relative to intrinsic value. The genesis of the implicit minority discount may arise from a misunderstanding of the assertion that stock prices represent minority values. Although some view the adjustment for the implicit minority discount as possible minority compensation for the wealth misappropriated by the majority, a direct adjustment according to the facts of the case would lead to a more economically efficient and equitable outcome. Because the value of minority shares that is derived from comparable company analysis is a minority value only in the sense that it is the value of the equity in the absence of a controlling stockholder, the adjustment for implicit minority discount transfers wealth from the controlling stockholders to the minority.

Chapter 11 Cross-Border Valuation Effects in Developed and Emerging Markets (Wenjie Chen)

Cross-border M&As have become an integral part of the global business landscape. In 2007, the value of cross-border M&A transactions amounted to $1,637 billion, which is a 21 percent increase from the previous record set in 2000. Historically, the majority of M&As have taken place between industrialized countries. In recent years, however, emerging markets started engaging in cross-border M&A activities. Developed and emerging markets have fundamental differences in institutions, legal environment, corporate governance, and factor endowments such as accessibility to relatively cheap labor. These differences have profound impacts on the participants in and outcomes of cross-border M&As. Studying these impacts is important in understanding the nature of cross-border M&As and their valuation effects on both target and acquiring firms.

Part III. The M&A Deal Process

Chapters 12–17 provide an overview of the M&A deal process. Chapters 12 and Chapter 13 offer a discussion on sources of financing and means of payments and cultural due diligence. Chapter 14 and 15 focus on the negotiation process. The final two chapters examine the postacquisition planning and integration process and issues related to organizational and human resources.

Chapter 12 Sources of Financing and Means of Payments in M&As (Marina Martynova and Luc Renneboog)

This chapter reviews the academic literature regarding an acquiring firm's choices of financing sources and the means of payment in corporate takeovers. The financing and payment decisions have a significant impact on the value of the acquiring firm. Investors take into account the information signaled by the choices of both the payment method and the sources of takeover financing when estimating the possible synergistic takeover value at the announcement. The financing decision is influenced by the acquirer's concerns about the cost of capital. In particular, in line with the pecking order hypothesis, cash-rich acquirers opt for the least expensive source of financing—internally generated funds. Acquirers operating in a better corporate governance environment benefit from lower costs of external capital. That is, debt financing is more likely when creditor rights are well protected by the law and court system, and the use of equity financing increases when shareholder rights protection is high. The takeover financing decision is closely related to the acquirer's strategic preferences for specific types of payment.

Chapter 13 Cultural Due Diligence (Ronald F. Piccolo and Mary Bardes)

The due diligence process associated with evaluating the viability of a merger, acquisition, or extended partnership most often comprises a comprehensive examination of strategic, economic, and financial metrics that estimate firm fit and expectations for economic return. Despite the vast amounts of hard data that characterize this process, a high failure rate remains for M&As, due in large part to conflicts in the merging firms’ organizational cultures. Managers in the due diligence process often fail to make valid assessments of the norms, values, standards, and traditions of merging firms; neglect the influence of an organization's culture on the behavior and attitudes of its members; and underestimate the challenges associated with integrating two otherwise diverse firms. This chapter presents a brief description of organizational culture with some suggestions for measuring culture in an organizational setting.

Chapter 14 Negotiation Process, Bargaining Area, and Contingent Payments (William A. Grimm)

This chapter describes the negotiation process using two hypothetical situations involving a large, publicly held company as the buyer and two types of sellers—a small, publicly held company and a small, privately held company. The major issues that are usually involved in each type of transaction are discussed. The chapter emphasizes the thorough preparation needed for the negotiation by both the buyer and the seller and discusses how the preparation differs for each. It also discusses the interaction among the issues being negotiated, which makes clearly defining the bargaining area around the price to be paid difficult.

Chapter 15 Merger Negotiations: Takeover Process, Selling Procedure, and Deal Initiation (Nihat Aktas and Eric De Bodt)

Recent literature in finance reveals that the takeover market during the deal-friendly decade of the 1990s was much more competitive than prior research had indicated. The chapter provides an analysis of the private portion of the takeover process. The results show that about half of all targets are auctioned among multiple bidders, whereas the remainder negotiates with a single bidder. The chapter documents the takeover process of 1,774 large U.S. deals announced during the period from 1994 to 2007, of which 847 negotiations (48 percent) involved no explicit competition and 927 auctions (52 percent) had multiple bidders. An empirical analysis of the sales procedure's determinants reveals that, consistent with auction theory, auctions are more frequent for smaller targets (relative to the acquirer), less diversified targets, and cases in which the number of potential acquirers is large. Finally, the chapter discloses a relationship between deal initiation and the choice of the sales procedure; auctions represent the preferred method when the seller initiates the transaction.

Chapter 16 Postacquisition Planning and Integration (Olimpia Meglio and Arturo Capasso)

The purpose of this chapter is to provide an in-depth analysis of the postacquisition process, which involves both planning and implementation processes. The integration process is a crucial part in making a merger or acquisition successful. This process can result in synergy and capability transfers that can produce real benefits for the combined entity. This process is vital to creating value and deserves careful planning and execution because it contains potential pitfalls that can be detrimental to postacquisition performance. The analysis in this chapter focuses on setting priorities according to acquisition goals, identifying the roles and competencies of the integration manager, developing reliable integration tools, and measuring acquisition performance.

Chapter 17 Organizational and Human Resource Issues in M&As (Siddhartha S. Brahma)

Success in M&As cannot be assured because many of them fall short of their stated goals. Although the strategy and finance literature dominate this field, relatively little attention is given to the organizational and human resource aspects of M&As. This chapter reviews the literature on this subject and suggests that organizational and human resource issues play a crucial role in shaping the M&A outcome. The organizational perspective presents the literature on the organizational-fit and process school. The decision-making process and the cultural integration process constitute the two views of the process school. On the other hand, the human resource perspective covers the areas of employees’ reaction, role of communication, social integration, postmerger identification, and organizational justice.

Part IV. Takeovers and Behavioral Effects

Chapters 18–21 provide an overview of takeover strategies and defensive takeover strategies in M&As. These chapters further discuss the impact of restructuring on bondholders and behavioral effects in M&As.

Chapter 18 Takeover Strategies (Shailendra Pandit)

Takeover strategies involve identifying potential takeover targets, determining the timing and terms of the offer, addressing competing bidders and target resistance, and navigating takeover negotiations to a successful conclusion. This chapter traces the antecedents of takeover strategies that include several external and internal factors such as macroeconomic and capital market conditions, taxes, regulatory environment, motivations of the involved firms, and potential competition from other firms. This material is followed by a discussion of specific forms of bidding approaches including the level of friendliness of the acquirer's approach, the form of compensation, and other contractual features that have consequences for the firms involved in both the acquisition and the actual outcome of the bid itself. Thus, the discussion in this chapter centers on the causes and effects of takeover strategies on acquirers.

Chapter 19 Defensive Strategies in Takeovers (Christian Rauch and Mark Wahrenburg)

Over the past decades, defense mechanisms against hostile takeover attempts have become both more versatile and increasingly complex. As a reaction to more sophisticated takeover strategies, M&A consultants and their clients have developed a vast array of preventive and remedial defense strategies to deter potential hostile bidders and fend off actual bids from hostile acquirers. This chapter introduces the most common and frequently used antitakeover strategies, while focusing on the economic evaluation of each strategy and examining cases that highlight the different strategies. To account for more recent developments, the chapter also provides a discussion of the current financial crisis and its effect on hostile takeovers.

Chapter 20 The Impact of Restructuring on Bondholders (Luc Renneboog and Peter G. Szilagyi)

This chapter provides an overview of the existing literature on the impact of corporate restructuring on bondholder wealth. Restructuring is defined as any transaction that affects the firm's riskiness by changing its underlying capital structure. Thus, restructuring extends beyond asset restructuring and includes transactions such as leveraged buyouts, security issues and exchanges, and the issuance of stock options. The chapter identifies major gaps in the literature, emphasizes the potential differences in bond performance between market and stakeholder-oriented corporate governance systems, and provides insights into methodological advances. Studies providing empirical evidence are often inconclusive and mainly focus on the U.S. data. Although the corporate bond markets in other countries are relatively less developed, findings in these markets should prove relevant.

Chapter 21 Behavioral Effects in M&As (Jens Hagendorff)

This chapter provides a synthesis of the applications introduced in behavioral finance literature regarding M&As. Most of the existing M&A literature is based on a neoclassical framework that views managers and investors as utility maximizing and rational. However, mixed findings regarding the realized performance effects of mergers are difficult to reconcile with this neoclassical view of acquisition activity. This chapter contends that having managers or investors relax the rationality assumption complements neoclassical theory and leads to a more realistic view of what causes mergers, merger waves, and merger underperformance. Further, emphasizing the potential consequences of how chief executive officer overconfidence affects executive pay offers a promising behavioral approach to why managers overinvest in the market for corporate control.

Part V. Recapitalization and Restructuring

Chapters 22–24 discuss issues related to various types of restructuring activities including financial restructuring, going private and leveraged buyouts, and international aspects of takeovers and restructuring.

Chapter 22 Financial Restructuring (Otgontsetseg Erhemjamts and Kartik Raman)

Corporate restructuring can encompass a broad range of transactions including changing asset portfolio composition through divestitures, asset sales, spin-offs, and M&As; altering capital structure; and changing the firm's internal organization. This chapter discusses financial restructuring activities that substantially change the capital structures of firms. Separate sections cover share repurchases, dual-class recapitalizations, exchange offers and swaps, and debt restructurings via private workouts and bankruptcy. While discussing the motivations and recent evidence for the financial restructuring activities, the interrelation between financial restructuring events and takeovers is examined wherever appropriate.

Chapter 23 Going Private and Leveraged Buyouts (Onur Bayar)

This chapter reviews some recent trends and motives for public-to-private leveraged buyout (LBO) transactions. The potential sources of value creation in such transactions include the following: improvements in managerial incentives and firm governance, improvements in operating performance and productivity, tax shield benefits of leverage, asymmetric information, and market timing. Value creation in these deals is also closely associated with the availability of debt financing in credit markets and general market conditions. The chapter describes the actors in the private equity industry, the key properties of a typical LBO transaction, recent private equity waves in the United States and other countries, and exit opportunities. The chapter also discusses the existing theory and evidence on the value created in going-private transactions. Lastly, the chapter offers some observations about the direction of future research.

Chapter 24 International Takeovers and Restructuring (Rita Biswas)

Cross-border M&As remain an increasingly important means of foreign expansion for firms. Firms that acquire targets in foreign countries are motivated by a wide range of factors including lower costs, better technology, expanded markets, and regulatory and tax considerations. While cross-border acquisitions offer unique benefits, they also present unique complexities in all three stages of the acquisition: (1) target identification, (2) transaction execution, and (3) integration. Acquirers consider the strategic context of the potential target when selecting the right firm from a global set of targets. While executing the transaction, acquirers decide on the form and vehicle of acquisition, manage cross-border tax planning opportunities and implications, and execute the valuation, taking into consideration the issues exclusive to multicurrency and multicultural settings.

Part VI. Special Topics

Chapters 25–29 examine special topics. These topics are joint ventures and strategic alliances, fairness opinions, the dual tracking phenomenon, the diversification discount, and partial acquisitions.

Chapter 25 Joint Ventures and Strategic Alliances: Alternatives to M&As (Tomas Mantecon and James A. Conover)

This chapter provides an analysis of the decision to expand the boundaries of the firm with M&As or by sharing control in alliances. During the period 1990 to 2008, at least one of these deals occurred every 22 minutes. Existing research suggests that firms prefer M&As over alliances. Firms choose alliances only when full integration is too costly. Equity joint ventures (JVs) are typically less common than other alliances but more common in cross-border deals when the host country presents low levels of economic freedom. Joint ventures can foster knowledge exchange and are preferred by firms in the presence of higher levels of uncertainty, risk, and opportunistic behaviors. The evidence is unclear about which of the alternatives creates more wealth for shareholders. Event studies suggest that buyers in M&As fare worse than parents in alliances, but M&As create more combined wealth. Long-term performance studies, however, yield inconclusive results.

Chapter 26 Fairness Opinions in M&As (Steven M. Davidoff, Anil K. Makhija, and Rajesh P. Narayanan)

When evaluating a merger or acquisition proposal, boards frequently seek fairness opinions from their financial advisors. This fairness opinion ratifies the consideration being paid or received as fair from a financial point of view to shareholders. This chapter describes how a Delaware Supreme Court ruling and Delaware corporate law combined to institutionalize fairness opinions and how the form and content of a fairness opinion results from concerns over limiting the liability associated with delivering the opinion. It then surveys the limited finance literature examining whether fairness opinions provide value to shareholders or instead serve the interests of the board and management at the expense of shareholders. The chapter also highlights the difficulties associated with conducting such empirical tests because of the way fairness opinions are sought and provided. The chapter concludes with some conjectures about the potential value of fairness opinions and raises questions for future research.

Chapter 27 How Initial Public Offerings Affect M&A Markets: The Dual Tracking Phenomenon (Roberto Ragozzino and Jeffrey J. Reuer)

Recent research in financial economics reports a phenomenon in which firms filing to go public become acquisition targets either shortly after executing the initial public offering (IPO), or even before the IPO takes place. This phenomenon, labeled dual tracking, raises important questions about the potential effects that IPOs may bring about in addition to their capital creation properties. Namely, at the most basic level, the question arises as to why IPOs may trigger subsequent M&A activity, especially because IPOs and M&As have been typically considered as separate corporate events and have not been studied jointly in research. Further investigation into the dual tracking phenomenon suggests the need to answer several questions: What properties of IPOs are most conducive to dual tracking and affect acquisition activities, structures, and outcomes? How might acquirers and sellers gain from dual tracking? Can entrepreneurs and venture capitalists stage their exit to include an IPO and a takeover, rather than considering either option as a substitute decision or as an independent, go/no-go decision? This chapter provides a discussion of how IPOs affect M&As to address these questions and several others.

Chapter 28 The Diversification Discount (Seoungpil Ahn)

Does corporate diversification destroy or enhance firm value? Although researchers on corporate diversification have explored this issue for decades, they are still searching for answers involving many aspects of corporate diversification strategy. In theory, corporate diversification can be both beneficial and detrimental to firm value. Much of the debate on the diversification discount is about whether the valuation impact of diversification is, on average, positive or negative. Although the cross-sectional evidence shows that this net effect of diversification is, on average, detrimental to firm value, ample evidence exists to the contrary. Therefore, the impact of diversification on firm value is not completely resolved. As with many cases in economic studies, the value of diversification is conditional on firm and industry characteristics. The value is also time-variant. Future research in the field should identify the conditions that are associated with value-enhancing and value-destroying diversification.

Chapter 29 Partial Acquisitions: Motivation and Consequences on Firm Performance (Pengcheng Zhu and Shantanu Dutta)

This chapter reviews the literature on partial acquisitions and focuses on the impact of partial acquisitions on target firm performance. The partial acquisition sample permits investigating both target firms’ structural and performance changes during the postacquisition integration process. This chapter summarizes the key motivations for undertaking partial acquisitions and reviews the empirical evidence on the short-term and long-term consequences of partial acquisitions on target firm performance. Furthermore, the chapter highlights the factors that may moderate the acquisition impact including the postacquisition governance and control change, the acquiring firms’ identities and motivations, and the external information environment. Overall, the literature shows that partial acquisitions improve target firm performance because the activist acquiring firms bring increased monitoring power and improved governance mechanisms.

SUMMARY AND CONCLUSIONS

Despite many theories and voluminous research, the subject of capital restructuring has elements of both art and science. The large proportion of unsuccessful M&As suggests that those entering such deals face many challenges. One of the measures of a deal is whether it creates market value. While economics can explain some of the forces at work, psychology also plays an important role. The following chapters help to identify key factors or drivers leading to success. Nonetheless, success in M&As is uncertain. Let's now begin a journey into the fascinating world of mergers, acquisitions, and corporate restructuring.

ABOUT THE AUTHORS

H. Kent Baker is a University Professor of Finance and Kogod Research Professor in the Kogod School of Business at American University. He has held faculty and administrative positions at Georgetown University and the University of Maryland. Professor Baker has written or edited numerous books. His most recent books include Survey Research in Corporate Finance: Bridging the Gap between Theory and Practice (Oxford University Press, 2011), Capital Structure and Financing Decisions: Theory, Evidence, and Practice (Wiley, 2011), Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects (Wiley, 2011), Behavioral Finance—Investors, Corporations, and Markets (Wiley, 2010), Corporate Governance: A Synthesis of Theory, Research, and Practice (Wiley, 2010), Dividends and Dividend Policy (Wiley, 2009), and Understanding Financial Management: A Practical Guide (Blackwell, 2005). He has more than 230 publications in academic and practitioner outlets including in the Journal of Finance, Journal of Financial and Quantitative Analysis, Financial Management, Financial Analysts Journal, Journal of Portfolio Management, and Harvard Business Review. Professor Baker ranks among the most prolific authors in finance during the past half century. He has consulting and training experience with more than 100 organizations and has presented more than 750 training and development programs in the United States, Canada, and Europe. Professor Baker holds a BSBA from Georgetown University; M.Ed., MBA, and DBA degrees from the University of Maryland; and MA, MS, and two PhDs from American University. He also holds CFA and CMA designations.

Halil Kiymaz is Bank of America Chair and Professor of Finance in the Crummer Graduate School of Business at Rollins College. Before joining the Crummer School, Professor Kiymaz taught at the University of Houston–Clear Lake, Bilkent University, and the University of New Orleans. He holds the CFA designation and has served as a grader for The CFA Institute. Professor Kiymaz maintains an extensive research agenda and has published more than 60 articles in scholarly and practitioner journals. His research has appeared in the Journal of Banking and Finance, Financial Review, Global Finance Journal, Journal of Applied Finance, Journal of Economics and Finance, Review of Financial Economics, and Quarterly Journal of Business and Economics, among others. He is the recipient of several research awards including the McGraw-Hill Irwin Best Paper Award and the Outstanding Research Award at the Global Conference on Business and Finance. He also serves on the editorial board of numerous journals. Professor Kiymaz has consulting and training experience with various governmental and public organizations such as the Central Bank of Turkey, Bankers Association, and Stalla. He has been listed in various biographies including Who's Who Among America's Teachers, Who's Who in Business Higher Education, Academic Keys Who's Who in Finance and Industry, International Who's Who of Professionals, and Marquis Who's Who. Professor Kiymaz received a B.S. in Business Administration from the Uludag University and an MBA, MA in Economics, and a PhD in Financial Economics from the University of New Orleans. Professor Kiymaz also holds visiting professor positions at the IMADEC University, School of International Business, Vienna, Austria; East Chinese University of Science and Technology, Shanghai, China; and Copenhagen Business School in Copenhagen.

Part I

Background

CHAPTER 2

Merger Waves

JARRAD HARFORD

Marion Ingersoll Professor of Finance, University of Washington

INTRODUCTION

The goal of this chapter is to provide a survey and synthesis of the literature on merger waves. Given the sheer volume of research on the subject of mergers, the chapter cannot discuss all the facets of this important topic. Thus, the chapter includes only some of the more important research on merger waves.

The chapter begins by discussing the motives for combining previously independent assets and then attempts to explain the clustering of such activity. While merger activity is motivated by a variety of factors, understanding what causes merger activity to cluster is critical. Because this clustered merger activity inside waves represents such a high proportion of all activity, understanding the drivers of clustering leads to an understanding of the main drivers of mergers.

MERGER MOTIVES

Many theories have been put forth to explain mergers. Some are rooted in the theory of the firm. Determining the right combination of jointly managed assets is clearly related to the question of the boundary between the firm and the marketplace as posited in Coase (1937), Alchian and Demsetz (1972), and others. A related strand of literature builds on Jensen and Meckling's (1976) discussion of the agency conflict between a corporation's managers and owners. Jensen (1986) lays out a theory where the agency conflict, aided by an abundance of free cash flows, results in value-destroying acquisitions. Still other theories center on behavioral issues such as hubris on the part of managers (Roll, 1986) or biases by market participants (Shleifer and Vishny, 2003). These theories are not mutually exclusive and each has some import for explaining merger activity. The following sections discuss each theory in more detail before surveying the evidence.

Theories Explaining Mergers

The major theories explaining mergers can be classified broadly into neoclassical, agency, and behavioral. Each is discussed in turn.

Neoclassical Theory

In an early survey of the evidence on mergers and acquisitions (M&As), Jensen and Ruback (1983) characterize the market for corporate control as one in which managerial teams compete to manage assets while shareholders act as mostly passive judges. In the market for corporate control, merger arbitrageurs and takeover specialists fill the role of intermediaries. In such a market, higher skilled managers who can get the most value out of an asset will gain control of that asset. Exchanges happen only because value can be created either through synergies or by replacing managers who suffer from low-skill or excessive agency problems.

The synergies could come from economies of scale or scope or from combining different technologies. Practitioners typically refer to two categories of synergies: cost reduction and revenue enhancement. Cost reduction synergies often come from economies of scale. For example, when two banks merge they do not need two headquarters, two back office operations, branches in close proximity to each other, and the like. They can provide largely the same level of service to a much greater customer base without a proportionate increase in the cost. Revenue enhancement synergies often come from economies of scope. For instance, when Oracle purchased PeopleSoft, this transaction immediately pointed to the possibilities of gaining more customers because Oracle could sell one integrated suite of software products. A similar argument was made when Delta merged with Northwest—the combined route map would connect far more city pairs, consequently attracting more customers.

Some merger-created synergies are due to market frictions. Lewellen (1971) proposes a purely financial rationale for mergers. He argues that acquiring assets with cash flows not perfectly correlated with a firm's existing assets’ cash flows lowers the volatility of the combined firm's cash flows, increasing its debt capacity and ability to utilize the tax deductibility of interest.

Similarly, others such as Erickson and Wang (2007) propose that profitable acquirers can essentially buy tax shields by purchasing a target with loss carry-forwards. Here, the synergy merely comes from uniting the tax shield represented by the carry-forward with the profits of the acquirer. The government provides all the synergies through reduced taxes.

Based partly on Myers and Majluf's (1984) pecking order theory emphasizing the importance of slack, Smith and Kim (1994) and others propose that some mergers can create synergies by uniting the financial slack of one company with the growth options of another. Smith and Kim (1994) find some evidence of value creation when high-slack, low-growth companies merge with low-slack, high-growth companies.

Relying less on frictions and instead on returning to the idea of a market for corporate control of assets, Jovanovic and Rousseau (2002) propose a theory based on differences in target and acquirer Tobin's q, which is called the Q-Theory of Mergers. They start with the fact that q-based investment theories predict that higher q firms should invest more than lower q firms. Jovanovic and Rousseau argue that the same prediction is applicable to mergers. The authors note that the empirical evidence supports the claim that high-q firms generally buy low-q firms. Furthermore, they conclude that mergers are a way for capital to transfer away from marginal projects and/or poor management to better projects and/or management.

Rhodes-Kropf and Robinson (2008) also use q in their explanation of merger activity but come to a different conclusion than Jovanovic and Rousseau (2002). They start by showing that high-q acquirers actually tend to buy high-q targets and likewise for low-q acquirers and low-q targets. Rhodes-Kropf and Robinson show that this like-buys-like result can be generated by a model based on asset complementarities and search frictions.

Agency Theory

As Jensen and Meckling (1976) point out, the separation of ownership and control in the modern corporation carries with it many benefits but also some costs. The costs stem mostly from the agency conflict resulting when ownership and management are separated. Jensen (1986) points out that this conflict—manifesting in disagreement over the optimal size of the firm, and when and how much cash should be paid to shareholders—is a particular problem when a firm has excessive free cash flows. He then applies this specifically to mergers by pointing out that maturing industries often have high free cash flows, leading to managers making potentially value-destroying acquisitions by diversifying into new lines of businesses.

Stulz (1988) follows Jensen (1986) and builds a formal model of self-interested managers with private benefits of control. When managers increase the fraction of their own stock held, there are two effects: (1) a decrease in the chance of a hostile takeover attempt, and (2) an increase in the price conditional on such an attempt occurring. Stulz shows that a unique fraction will balance the two effects. Stulz also uses the model to explain why shareholders vote for takeover defenses: Some defenses have the same effect as increasing managers’ fraction of stock, resulting in a higher price should a takeover attempt occur.

In a novel application of agency theory, Gorton, Kahl, and Rosen (2009) propose a merger theory that combines agency problems with efficiency merger motives. In their model, a shock to an industry creates value-increasing merger opportunities. Managers have private benefits of control that they would like to preserve. Anticipating the possibility of being acquired in one of these mergers, some managers will undertake defensive acquisitions in an attempt to become too big to be bought. Other managers will undertake acquisitions designed to make their firm more attractive as a target, garnering a higher premium. The authors test and provide support for their model using data from the 1980s and 1990s.

Behavioral Theory

Roll (1986) surveys the evidence on mergers, concluding that it is consistent with a simple hubris-based explanation for merger activity. He points out that bids take place above the current market price, increasing the likelihood of bidders making positive valuation errors. Drawing from the psychology literature on overconfidence, Roll posits that managerial hubris of well-performing bidding firms suggests that bidding firms are simply overpaying for their targets. His was the first paper to suggest a behavioral explanation where a decision maker's psychological bias drives the activity. He argues that this bias matters because it takes repeated failures for people to update beliefs about themselves, but most chief executive officers (CEOs) participate in only a few acquisitions. While both agency- and hubris-based hypotheses produce value-destroying transactions, they assume different motives for the managers. Under the agency-based hypothesis, managers are aware that they are undertaking a value-destroying acquisition but do it anyway because it helps them personally. Under the hubris-based hypothesis, managers believe they are undertaking a value-increasing acquisition but are incorrect due to their overconfidence.

The paper by Roll (1986) was published before behavioral finance gained popularity and even before the debate over possible evidence of inefficiencies and persistent market mispricings. In an influential paper, Shleifer and Vishny (2003) note the strong correlation between merger activity and stock market appreciation. They propose a model of mergers driven by the stock market. Specifically, bidder managers, who are aware that their stock is overvalued, seek to use it to finance the acquisition of a target (and its real assets) before the misvaluation is corrected. The model contains two important assumptions. First, the market is inefficient in that it does not, on average, fully adjust the bidder's stock price downward upon the announcement of a stock-financed acquisition. Second, target managers must rationally accept the overvalued stock, so they are assumed to have short horizons compared to those of the bidder managers. Thus, target managers will accept the overvalued stock and sell it.

Again looking at the relation between the stock market and merger activity, Rhodes-Kropf and Viswanathan (2004) construct a model that includes market mispricings, producing over- and undervaluation. However, in their model, both bidder and target managers act rationally. Specifically, bidders and targets can be undervalued and overvalued and the valuation is driven by marketwide and firm-specific components (the managers do not know which). When marketwide overvaluation is high, targets mistakenly overestimate the synergy-based premium because they rationally believe that the bid may simply be a high synergy bid. This leads targets to rationally accept the offer even if it involves overvalued bidder stock, creating waves in M&As that are tied to value even in this rational environment.

Evidence on Mergers

The past 30 years has witnessed an explosion in research and evidence on mergers. This section briefly surveys the evidence and relates it to the theory discussed above.

Foundational Evidence

In the survey discussed earlier, Jensen and Ruback (1983) note that M&A announcement returns are clearly large and positive for the target, but are only positive for the bidder in a tender offer and are indistinguishable from zero in a merger. The target's stock price reaction represents two effects: the premium and a reassessment of the target's stand-alone value. Bradley, Desai, and Kim (1983) disentangle these two effects by looking at failed mergers. They note that in cases where no new bid emerges for the target, the target's price returns to its prebid level (on average), suggesting that the target stock price reaction is due to the expected premium.

Healy, Palepu, and Ruback (1992) study the 50 largest mergers from 1979 to 1984 and find that asset productivity improves after the merger, increasing overall operating cash flows (especially in horizontal mergers). Announcement returns are correlated with subsequent operating improvements, suggesting that revaluations at announcement are due to the pricing of these synergy gains. Research and development (R&D) and capital spending is not cut, on average. These results support efficiency arguments for mergers, as well as the efficient markets hypothesis with respect to the announcement return. They stand in contrast with Scherer and Ravenscraft (1989), who document performance declines in the 1960s wave, which was characterized by many diversifying acquisitions.

Maksimovic and Phillips (2001) take a wider view of M&As by studying plant-level data in what they call the market for corporate assets. Their main finding is that more productive firms buy assets, while less productive firms sell assets during expansions. Firms end up buying in divisions that have high productivity and selling from low productivity divisions. Further, productivity improves at a plant postpurchase. This is largely consistent with a profit-maximizing model with scarce managerial talent and inconsistent with empire building.

Bidder Stock Price Reaction

The bidder's stock price reaction is even harder to parse than the target's price. Among other factors, the market could be reassessing the bidder's internal growth opportunities, the skill of the management, the impact of the bid's financing on the combined firm's capital and ownership structure, and of course, the premium paid relative to potential synergies created. Fuller, Netter, and Stegemoller (2002) take a novel approach to disentangling these factors. They study firms making five or more acquisitions within three years. Through this, they attempt to isolate the characteristics of the target and the specific bid from those of the bidder. The authors find that the best bidder stock price reaction comes from a public firm buying a relatively large private firm for stock. The explanation is twofold. First, when buying a private firm, the bidder generally gets better pricing because it is providing liquidity to the target owners. Second, by using stock to buy out the concentrated owners of the target, the bidder effectively creates a new set of blockholders with incentives to monitor the combined firm's management. Based on this and other evidence in their paper, Fuller et al. draw the overall conclusion that illiquidity discount, tax, and control effects exist in the merger market.

Moeller, Schlingemann, and Stulz (2004) take a different approach to understanding the bidder stock price reaction, examining 12,023 public acquisitions from 1980 to 2001, which is the largest sample to date of public acquirers. They conclude that the potential for hubris as an explanation for large firm decisions exists. That is, acquisitions by small firms are overwhelmingly value-creating (positive value for bidder and for combined firm), but large bidders on average destroy value in acquisitions. Interestingly, even though the vast majority of acquisitions create value, the aggregate effect is net value destruction because the value-destroying acquisitions are typically undertaken by large acquirers to large targets, resulting in a greater amount of destroyed value. The authors’ evidence is also consistent with an agency explanation wherein managers of larger firms have smaller ownership stakes, thus making value-destroying acquisitions in order to create personal net benefits.

Agency Hypothesis

Some papers specifically examine the agency or free cash flow (FCF) hypothesis. For example, Lang, Stulz, and Walkling (1991) find evidence in favor of the FCF hypothesis by documenting a negative correlation between acquirer free cash flows and acquisition announcement returns. Harford (1999) examines cash-rich firms and finds that not only are they abnormally active as acquirers, but also they tend to destroy value with their acquisitions. Applying the more recently popular Gompers, Ishii, and Metrick (2003) governance index, Masulis, Wang, and Xie (2007) find lower returns for acquirers with high governance indexes (indicating more entrenched managers).

Market-Power and Collusion

One possible source of gain and hence motivation for merging is the desire to increase industry concentration to gain market power or enable collusion. Thus, the gains from a merger would be wealth transfers from consumers or competitor shareholders. Eckbo (1983) and Stillman (1983) examine this hypothesis explicitly. Rivals have positive returns at the horizontal bid announcement, but these returns do not decrease at government challenge announcements. This finding is inconsistent with the market power hypothesis. It is more in line with a hypothesis put forth by Song and Walkling (2000) that the share prices of firms similar to a merger target anticipate the possibility of those firms becoming targets themselves and rise at the initial acquisition announcement. Fee and Thomas (2004) and Shahrur (2005) further examine the merger impact throughout the supply chain and determine that customers and suppliers do not incur large losses. They also find evidence that mergers force upstream efficiencies, which in turn force those suppliers who cannot adapt to lose out. Again, there is little to no evidence that merger gains come in the form of wealth transfers from customers or suppliers.

Another possible source of wealth transfers is the bondholders. Research here has been hampered by a lack of daily bond prices for the target and bidder. However, the increase in data availability has permitted some studies such as the work by Billett, King, and Mauer (2004), who find that wealth-transfers are either nonexistent or at best second in importance to synergy effects on bondholders. Also, since the early 1990s, most corporate bonds carry event risk covenants that largely protect bondholders in the event of an acquisition.

Betton, Eckbo, and Thorburn (2008) undertake an exhaustive review of the mergers literature and in so doing use the entire Securities Data Company (SDC) database, finding that in all samples, targets have positive three-day cumulative abnormal returns (CARs) around the announcement day. About one-third of the target's total price appreciation happens in the preannouncement run-up when rumors and insider trading begin moving the price up. Schwert (1996) studies this prebid run-up and concludes that it is essentially a cost to bidding firms in that they must mark up the acquisition price over that run-up rather than counting that run-up as part of their overall premium.

For the bidder, Betton et al. (2008) find that the most consistent positive announcement returns are found for small bidders, cash-only deals, deals involving private targets, and deals taking place from 1991 to 1995 (early in the 1990s merger wave). Their evidence shows that the most consistent negative returns are for large bidders and stock-only deals involving public targets.

Exhibits 2.1 and 2.2 present some summary statistics for more than 19,000 bids by public bidders for U.S. targets from 1985 to 2009. The results are broadly consistent with the findings cited above and also confirm the work of Fuller et al. (2002), concluding that one cannot study the payment method in isolation from the target form.

As Panel A of Exhibit 2.1 shows, the announcement return distributions are highly skewed such that the means are generally larger in magnitude than the medians. Overall, mergers create a small amount of value for the bidders on average. The mean is greater in stock mergers (1.6 percent) than in cash deals (1.1 percent), but that relation is reversed when looking at the medians (–0.1 percent vs. 0.4 percent). Target form clearly matters: Bidders have large and positive stock price reactions to acquisitions of private firms or subsidiaries. In contrast, they have significantly negative returns, on average, to acquisitions of public targets.

Exhibit 2.1 Announcement Returns for Public Bidders Upon Announcement of a Bid for a U.S. Target from 1985 to 2009

Given the importance of both payment method and target form, Panel B of Exhibit 2.1 presents results detailed by both characteristics. The results confirm those of Fuller et al. (2002). Stock-based acquisitions of private targets are met with a greater announcement return than cash-based acquisitions of private targets (this is the effect of creating a blockholder as discussed earlier). The reverse is true with public targets; acquisitions of public targets using all or partial stock are value-destroying for bidder shareholders. However, buying public targets with cash is value-creating.

Finally, the results in Exhibit 2.2 for the target shareholders in the subsample of public target deals are unsurprising. Target shareholders enjoy a large positive gain upon announcement due to the typical premium over the market price that the bidder offers. Cash offers have a higher reaction, possibly due to the greater value certainty provided by such offers.

Exhibit 2.2 Announcement Returns for Target Shareholders in Bids by Public Firms from 1985 to 2009

Exhibits 2.1 and 2.2 present data for all bids by public firms irrespective of merger waves. Indeed, most theory and empirical work on mergers attempts to hypothesize and test motives for mergers without regard to the time-series properties of aggregate or industry-level merger activity. As discussed in the next section, there has long been a nascent strand of literature examining the clustering of merger activity. Work in that field has been more active in the last 10 to 15 years, bringing with it a far greater understanding of the drivers of merger activity.

MERGER WAVES

The fact that mergers occur in waves is well established. As Exhibit 2.3 shows, a clear clustering of aggregate activity occurs in the time series. Jovanovic and Rousseau (2002) show that this clustering extends back with peaks in merger activity taking place in the 1920s and at the turn of the twentieth century. Indeed, the merger wave around 1890 has been called the monopolization wave, serving as the primary motivation behind the Sherman and Clayton Antitrust Acts in the United States.

Exhibit 2.3 The Fraction of U.S. Public Firms Acquired by Year

Note: The graph displays merger activity over time.

Early research into merger waves advanced on several fronts. Some work set about formally establishing via statistics that merger activity does indeed occur in clusters. Golbe and White (1988) note that despite the common assertion that mergers occur in waves, no one has actually proven this to be the case. Using a time series that stretches from 1895 to 1989, they fit a sine wave function to the data and show that the function predicts the peaks and troughs of actual merger activity fairly accurately.

Town (1992) takes a similar purely statistical approach. He shows that objectively one can fit a two-state, Markov switching-regime model to the time series of merger activity. This confirms that merger activity is best characterized by waves or periods of unusually high activity surrounded by periods of low activity.

Melicher, Ledolter, and D’Antonio (1983) undertake an examination of the time-series relation between aggregate merger activity and macroeconomic factors. They expect to find that business conditions would have significant explanatory power for aggregate merger activity. Instead, they find a weak correlation, indicating that changes in production lag behind merger activity. They do, however, uncover a strong correlation between capital market conditions and merger activity. Specifically, aggregate increases in stock prices and, to a lesser extent, decreases in interest rates lead to merger activity. The authors conclude that since merger negotiations start about two months before announcement, negotiations begin at a time when capital market conditions indicate receptiveness and lower financing costs.

Becketti (1986) also examines the correlation between macroeconomic variables and merger activity. He focuses on the S&P 500 return, interest rates, gross national product (GNP), and capacity utilization. He finds the strongest support for interest rates and capacity utilization. Specifically, merger activity responds negatively to increases in interest rates and positively to capacity utilization, suggesting that firms attempt to add capacity quickly through acquisition when utilization is high. His results for the aggregate stock return are mixed, in contrast to Melicher et al.'s (1983) findings. However, Becketti confirms their finding of little correlation between aggregate production and merger activity.

Building on the prior work on aggregate merger waves, Mitchell and Mulherin (1996) document clear clustering of waves within industries, formally showing that the clustering is too great to be random. They further propose some explanations for clustering, tying it to