It Pays to Follow the Leader: Acquiring Targets Picked by Private Equity

In a fascinating paper relating to deal competition, Amy Dittmar and her coauthors discuss the percentage of time competing bids are made by financial firms (23%) and discusses the motives, returns and deal structures associated with strategic vs. financial bidders.  It turns out that it pays for strategic buyers to "Follow the Leader" when the leader is a financial firm.    Amy summarizes the paper below with a link provided at the bottom of the post for a complete download of the article.  

All the best,

Ralph

Summary of “It Pays to Follow the Leader: Acquiring Targets Picked by Private Equity”

By: Amy Dittmar (University of Michigan), Di Li (Georgia State University) and Amrita Nain (University of Iowa)

Financial bidders like private equity firms often compete with corporate bidders for the same target. For example, over the last 27 years, 23% of all competing bids were made by financial sponsors. Even though financial bidders and strategic bidders often purse the same target firms, their motives and methods of acquisition differ. Financial bidders are believed to be skilled at selecting undervalued targets with a high potential for cost cuts and revenue growth. While corporate buyers may share operational synergies with the target firm, financial buyers rely primarily on improving the stand-alone value of the target firm or buying undervalued assets. In addition, financial buyers face shorter investment horizons than corporate buyers and possibly incentivize target management differently.

In this paper, we examine how the presence of financial sponsor competition affects corporate buyers. There are several reasons why the presence of financial sponsor competition may affect the returns and deal structure of corporate acquirers. First, financial bidders are considered experts in the business of identifying undervalued targets. Gains from acquiring an undervalued target may accrue to any winning bidder who pays a similar premium for the target. Second, existing research show that private acquirers pay significantly lower premia than public acquirers and that financial bidders have lower average valuations than strategic bidders.[1] Thus, a corporate acquirer competing with a financial bidder (which is typically private) may win the auction at a lower premium than when it competes with another public corporate firm. Third, financial bidders typically undertake all-cash acquisitions, often financed with debt. Existing theory suggests that acquirers use the cash component of a bid to signal the value of an acquisition. If the value to a corporate bidder from acquiring targets selected by private equity is different, then the cash component of the deal may also differ depending on the identity of the competitor.

Using a sample of approximately 100,000 merger bids made between 1980 and 2007, we find that corporate acquirers who purchase targets that financial buyers also bid on outperform corporate acquirers who buy targets bid on by corporate firms only.  We find that corporate acquirers competing with financial buyers pay significantly lower premiums and pay a higher fraction of the deal in cash.  However, accounting for these differences, deal characteristics, acquirer abilities, and observable target characteristics cannot explain this difference in returns. Corporate acquirers have higher returns when they follow a first bid by a financial buyer rather than a first bid by another corporate buyer. Specifically, acquirers earn about 12% greater abnormal returns in the 180 days following announcement if they follow a financial bidder rather than following a corporate bidder. The results suggest that financial bidders identify targets with high potential for value improvement and winning corporate bidders are competent in exploiting this potential.

The complete paper may be downloaded here.

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[1] See Bargeron, Schlingemann, Stulz, and Zutter (2008) and Gorbenko and Malenko (2010)