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.

Enjoying the Quiet Life? –commentary

This paper uses a clever check for reverse causality.  The authors find that for firms whose incorporating state adopts anti-takeover laws in the preceding twelve months, wages rise and productivity falls.  The reverse causality story is that rising wages (perhaps due to union pressure) and falling productivity threaten firms in a certain state, and therefore make that state more likely to enact anti-takeover laws.  The authors’ story depends on causality in the right direction.

The paper’s main tests use a binary variable BC to indicate whether a firm’s incorporating state enacted anti-takeover laws in the prior 12 months.  The coefficients on BC in the several regressions are the paper’s main findings.

In the reverse-causality check, the authors replace BC with four dummy variables:

  • Before-1 for firms incorporated in states that had not yet passed legislation but would do so in the next 12 months
  • Before0 for firms incorporated in states that had passed legislation in the prior 12 months
  • After 1 for firms incorporated in states that had passed legislation between 12 and 24 months prior
  • After2+ for firms incorporated in states that had passed legislation two or more years previously

Significant coefficients on Before-1 would have suggested that legislation was passed in response to an already-changing business environment.

Before0 was the variable of primary interest.

Small and Insignificant coefficients on After 1 and After2+ would have suggested that the effects of legislation were short-lived and therefore economically much less interesting.

In this case, the coefficients on Before-1 were small and statistically insignificant, ruling out the reverse causality.  The coefficients on After 1 and After2+ were significant and even larger than the coefficients on Before0, strengthening support for the authors’ story since their reported effects of anti-takeover laws continued to grow in the longer term.

Enjoying the Quiet Life? Corporate Governance and Managerial Preferences

Bertrand, Marianne, and Sendhil Mullainathan, 2003, “Enjoying the Quiet Life?  Corporate Governance and Managerial Preferences,” The Journal of Political Economy 111 (5), 1043-1075.

Purpose:  This paper examines the effect of anti-takeover laws on a variety of firm behaviors.

Findings:  Following the passage of anti-takeover laws, blue-collar wages rise 1%, white-collar wages rise 4%, and plant creation and destruction both fall so that firm size does not significantly change.  Capital expenditures are unaffected.  Total factor productivity falls.   Return on capital falls by 1%.  Findings contradict stakeholder theory that proposes increased efficiency when workers are paid more.  Findings contradict “empire-building” theories of corporate governance that suggest unfettered managers opt to increase firm size.

Motivation:  The reduced-form agency problem is our assumption that managers desire to pursue their own goals, which may not align with shareholders’ best interests.  There are many theories—but no consensus—regarding what managers’ personal goals actually are.

Data/Methods:

  • Longitudinal Research Database details plant-level employment and wages and plant creation and destruction.
    • The LRD does not include data on workers’ age, education, or tenure.
  • Compustat includes firm-level financial data, and each firm’s state of incorporation.
  • The Census of Auxiliary Establishments has better data on white-collar workers than the LRD.
    • These data are limited to the firm level (matching to specific plants is not possible)
    • These data are not available in every year, so we cannot analyze the trend
  • Corporate governance and firm behavior are endogenous, but this is overcome by studying anti-takeover laws passed by several states at different times.  The laws weakened governance by limiting the threat of hostile takeover, but were not driven by specific characteristics of any firm.  Laws were also passed at different times, so many firms belong both to the treatment group and to the control group in different years.
  • Analysis of firm-level outcomes
    • Difference-in-differences using firms incorporated in states that recently passed anti-takeover laws as the treatment group
  • Analysis of plant-level outcomes
    • The laws passed affected all firms incorporated in the passing state, regardless of the actual plant location
    • Control for regional economic and political variation by considering plants located in the same regions, one incorporated in a passing state, and one incorporated in some other state
  • Check for reverse causality, whereby states with rising wage pressures are more likely to pass anti-takeover legislation.  We do not find significant evidence of this.

Conclusions:  Anti-takeover legislation does change firm behavior.  Managers pay blue-collar workers more and pay white-collar workers much more, thus transferring more benefits to stakeholders.  Contrary to stakeholder theory, this benefit to stakeholders does not create overall improvement, as firm efficiency declines.  Managers avoid either opening or closing plants, undermining the “empire-building” view of manager preferences.  Managers appear to prefer “the quiet life,” with less employee conflict and fewer hard decisions.

commentary

Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

Jensen, Michael C., 1986, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” The American Economic Review 76 (2), 323-329.

Purpose:  This paper develops a theory linking debt, agency costs of free cash flow, and corporate takeovers.

Theory:  Managers seek to maximize their own influence, and not necessarily shareholder return.  They also have discretion over free cash flow, which represents an agency problem for firms with high free cash flows and low growth prospects.  Debt can be used to limit managers’ discretion over cash flows, and so increases in leverage can create value for shareholders beyond the tax implications.

  • Debt holders can force firm reorganization without bankruptcy more quickly and easily than equity holders.  This means higher-leveraged firms tend to be leaner and better managed.
  • Takeover targets should include firms with poor earnings and poor management, or firms with excellent earnings that management does not use to create value.
  • Lack of growth opportunities frequently leads to the undertaking of value-destroying projects.  Firms pursuing diversification and firms in industries with overcapacity often fit in this category.
  • These firms ought to see more takeovers, threats of takeovers, and subsequent debt increases.

Empirical Evidence:

  • Evidence from LBOs and going-private transactions
    • Most firms that are taken private are those with low growth and high potential for free cash flows—hence, high agency costs.  Strip financing (all bond-holders hold equal proportions of debt in each tier of seniority) reduces conflict of interest among bond holders, which gives them more power over the firm.
    • Very few of these transactions have gone into bankruptcy, suggesting that debt holders can force management efficiency and limit suboptimal investments.
  • Evidence from the oil industry
    • During the 1970s, oil prices increased and optimal capacity decreased, so that oil firms were both highly profitable and destined to shrink.  Oil managers continued investing in exploration & discovery projects that returned less than the cost of capital.
    • Around this time, oil companies began to merge and restructure under threat of takeover.  They increased leverage and cut value-destroying investments.

Conclusions:

  • Managers of firms with low growth opportunities can’t be trusted with high cash flow.
    • Leverage can be used to limit the free cash flow agency problem.
  • Firms with high cash flows and low growth opportunities should be prime takeover targets.
  • Acquisitions financed with debt and cash should create more value than similar transactions done with equity.