Do Acquisitions Relieve Target Firms’ Financial Constraints?

Erel, Isil, Yeejin Jang, and Michael S. Weisbach, “Do Acquisitions Relieve Target Firms’ Financial Constraints?” Journal of Finance, forthcoming as of Aug 2014

Purpose:  To ask whether a target company’s access to capital improves after an acquisition.

Motivation:  Managers often cite, as an argument for acquisition, the ability of the acquirer to finance the target company’s investment opportunities.  It is implicitly claimed that the target is financially constrained, but will be less constrained after the takeover.

Findings:  Takeover targets do seem to be financially constrained, and the constraints weaken after acquisition.  Cash holdings in the targets decline by 1.5%, investment levels increase, the sensitivity of cash to cash flow falls from 10.4% to zero, and cash flow sensitivity of investment also falls.  These effects are significant only for independent targets, which were more likely to be financially constrained than targets who were subsidiaries.  In a similar vein, the effects are strongest for the smallest tercile of target firms.

Data/Methods:  Post-acquisition financial data on U.S. companies is not publicly available, but most European countries require subsidiaries to publicly release such information.  The data comprises before-and-after data for 5,187 European companies who were acquired during the period 2001-2008.

  • Measure before-and-after cash policies of the target
    • Cash levels
    • Cash flow sensitivity of cash
    • Cash flow sensitivity of assets
  • Measure before-and-after investment policies of the target
    • Cash flow sensitivity of investments
  • Measure sensitivity of cash in [former] target to cash flows
    • In whole acquiring firm (including former target)
    • In all other departments of acquirer (not including former target)
  • Compare acquisition effects for targets of different size and sales growth, holding acquirer constant
  • Verify whether any effects are observed for firms very similar to the targets, but which were not acquired

Conclusions:  After firms are acquired, they tend to reduce cash holdings and increase investment, and their cash flow sensitivities of both cash and investment decline.  These changes in cash and investment policy are most notable in very small, independent targets and are much less significant for larger firms or subsidiary firms that are acquired.  There are no significant effects for firms that were not acquired, but were comparable to target firms.  These results suggest that financial constraints relax or disappear post-acquisition, especially for the firms most likely to be constrained.  It appears unlikely that this phenomenon is due to the other departments of the acquirer cross-subsidizing the former target’s investments; the easing of financial constraint is probably due to the target becoming part of a larger firm.