Friday, October 19, 2012

Acquisition Returns and Unresponsive Toads

Financial academics have been analyzing mergers in a scientific fashion for over 30 years.  One thing that has always puzzled me about this research is the accepted result that bidding firms either break even from acquisitions or lose a few percent on the deals they make.  (This tendency,  incidentally, helps explain one arbitrage strategy in stock deals, buy the target and short the bidder.)

But accepting this result doesn't tell us why bidders would undertake such deals.  Many explanations have been given.  Until recently, the arguments that seemed most plausible were a) that returns were driven down by competition for the target (bidding wars) or b) that the bidding firms get carried away with their own power - believing that they are endowed with greater abilities to manage a target.  Obviously, these two items are related.  The difference is that the explanation under (a) still allows for bidders making profitable deals.  Explanation (b) implies overpaying.

On Monday, I'll present new evidence from research we have conducted showing that bidders do indeed earn significantly positive abnormal returns when deals are announced - we just have to measure them correctly.  But our results don't imply that explanations (a) or (b) are incorrect.  All three explanations can and probably do hold water.  Competition does drive down returns, and while the typical deal is profitable when measured correctly, many deals lose money for bidders.

So today, I focus on the hubris explanation.  This idea was  first mentioned in the academic literature by Richard Roll in 1986 but I conclude with a non-academic and more entertaining analysis of the issue - a quote from Warren Buffett.

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

On Monday - what impacts returns to acquiring firms and how to measure them more accurately.

Have a great weekend,


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