There is a stream of finance research focusing on the performance of firms involved in mergers and acquisitions (M&As). Studies related to stock abnormal returns following a takeover announcement have reached a consensus that target firms’ shareholders benefit from the M&As. Nevertheless, acquiring firms’ shareholders may incur negative returns (Agrawal, Jaffe and Mandelker, 1992; Gregory, 1997) or neither gain or loss from M&A events (Frank, Harris, and Titman, 1991).
Moreover, if the combined equity value increases as a result of the takeovers (Jensen and Ruback, 1983), it is still difficult to recognize whether the equity value increases in takeovers are from real economic gains or market inefficiencies. Therefore, some scholars have suggested using accounting indexes to measure firms’ post-takeover performance (Healy, Palepu, and Ruback, 1992).
Current studies have already focused on the determinants and consequences of M&As. For example, scholars have stated that synergies can result from knowledge-transfer process, social networking, and more resources gaining from target firms.
Bresman, Birkinshaw and Nobel (2009) state that knowledge management is more important for firms to maintain their competitive advantages than before. The acquirers can reinforce their knowledge base through the knowledge-transfer process during acquisitions, thereby helping acquirers to expand into new markets rather than competing in the originally competitive market. In addition, Kiessling and Richely (2005) mention that synergy can stem from acquiring intangible assets such as social networking. When company acquires the target firm for its network and relationship, it sends a signal that the firm must believe it could generate more value through the network or relationship than others, or its acquisition move would be meaningless (Wernerfelt, 1984).
There are still more studies discussing the rationale behind M&As. Williamson
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(1973) brings the transaction cost theory to indicate that the purpose of taking acquisition is to minimize the sum of production and transaction cost. Also, from the resource-based view (Wernerfelt, 1984), a firm can maximize its value by obtaining target firm’s valuable resources through acquisition (Madhok, 1997; Das and Teng, 2000).
Nonetheless, prior studies seem to ignore the impact of different types of M&A behavior on firm’s post-takeover performance, since there has been a trend for firms to take sequential acquisitions rather than one-time acquisitions. Therefore, we will focus on this issue and employ the real option theory to try to explain this phenomenon.
Companies consider taking sequential acquisitions for several reasons. On the basis of real option theory, by acquiring fractional shares of the target firm, the acquirer can obtain more internal information than outsiders. Accordingly, transforming into an insider of the target firm eliminates downside risks of asymmetric information situation. In other words, if the acquirer finds out the target is an unfavorable investment, it can stop investing more, thereby avoiding a huge sum of loss than one-time acquisition’s costly exit in the bad-state situation.
Consequently, enterprises can take sequential acquisitions as real option for them to eliminate the downside risks through partial acquisitions of shares. In contrast, if target firms’ performance are getting better than they have expected before, they can continuously invest in the targets with lower potential downside risks because they already obtain more information through the process and eventually merge all of them.
Because of the above consideration, we would like to compare whether different M&A behavior will have an influence on the post-takeover operating performance based on real option theory in this research.
More specifically, we believe sequential acquisition as a role to help reduce potential downside risks and preserve the opportunity for future growth of target firm. In contrast,
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one-time acquisition enables the acquirer to obtain new resources such as information, knowledge, and social networking at one time, and to combine these new resources with their own to create the synergy. In consequence, whether sequential or one-time acquisition will improve more of the firm’s performance is what we concern.
Precedent studies research on this issue, however, have not reached an agreement.
Jiao (2010) investigates this topic with samples in China industry and claims that firm’s operating performance of one-time acquisition is better than sequential acquisition. In contrast, Lee (2011) uses the pharmaceutical industry data in the U.S and states that taking sequential acquisition is better for the firm’s operating performance than one-time deal.
Still, Chang (2012) has consistent findings with Lee (2011) when using pharmaceutical industry data in Europe, claiming that sequential acquisition is better than one-time deal.
Nevertheless, previous studies consider merely acquirer’s operating performance without matching a comparison group to determine the acquirer’s abnormal operating performance. As a result, it is worthwhile to figure out the relationship between M&A behavior and the firm’s operating performance under a more appropriate measurement structure.
In conclusion, acquirers taking sequential M&As have worse abnormal operating performance than one-time deals in one-year measurement, while the negative effects of taking sequential M&As will be alleviated when firms have less resources or higher debt-to-equity ratio. On the other hand, there is no significant difference between sequential and one-time M&As when we measure the three-year abnormal operating performance.
This study is then organized as follows. The next chapter gives a review of previous literature and the development of hypotheses. Chapter 3 describes data and methodologies.
Chapter 4 presents the empirical results related to abnormal operating performance of acquiring firms. Finally, Chapter 5 provides the conclusions and suggestions.
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Chapter 2 Literature and Hypotheses Development
We now discuss M&A studies in order to develop our hypotheses. First, we review strategic studies of M&A motivation for acquiring firms and empirical evidences of operating performance to develop the Hypothesis 1. Then we derive our Hypotheses 2a, 2b and 3 about M&A behavior and operating performance on the basis of real option theory and resources-based theory.
2.1 Abnormal Operating Performance Following Mergers and Acquisitions
Research on firm’s stock returns following M&As have already reached a consensus that much of the gains accrue to shareholders of the target firm. Acquiring firms’
shareholders incur negative returns (Agrawal et al., 1992; Gregory, 1997) or neither gain or loss from M&A events (Frank, Harris, and Timan, 1991). Besides, if the combined equity value increases due to the takeovers (Jensen and Ruback, 1983), it is still difficult to recognize whether the equity value increases in takeovers are from real economic gains or market inefficiencies (Healy, et al, 1992). Therefore, some scholars suggest using accounting indexes to measure firms’ post-takeover performance, thereby forming a second important stream of M&A research on firm’s operating performance.
However, operating performance empirical evidences using accounting measures do not reach an agreement on the effect of acquisitions. Some scholars report losses, for example, Ravenscraft and Scherer (1987) find out a significantly negative relationship between operating ROA and tender offer activity. They study 471 acquirers between 1950 and 1977 that firms with tender offer activity are 3.1% less profitable than firms without the M&As, ceteris paribus. While other scholars report gains for acquiring firms such as Healy, Palepu, and Ruback (1992). They choose 50 largest U.S. mergers between 1979 and mid-1984 to study the post-takeover performance, using industry performance as a
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benchmark.
In terms of strategic management perspectives to review the M&A rationale, the motivation can be classified into three dimensions, i.e., personal, economic and strategic reasons. Certain companies take M&As for management’s own purpose and not for companies’ benefits. Others attempt to solve problems due to economic downturns. Still others take M&As out of strategic reasons, aiming to enlarge market share or to improve the company’s sales. Additionally, some researchers indicate that firms are capable of creating additional value through the procedure of acquisitions. Kiessling and Richey (2005) introduce the social networking theory to account for that value is generated by additional network relationship obtained from the target firm. Despite M&As are often referred to as failure regarding the post-performance measure derived from financial statements, these firms believe that acquiring target firms may provide more value through integrating target firms’ social network relationship. And this value enables the acquirers to expand their client bases and to obtain more information regarding the entire industry which could not be demonstrated on the financial statements analysis.
Furthermore, according to the resource-based view, Das and Teng (2000) point out that firms can enhance their competitive advantages through efficient management and acquiring valuable resources from their competitors. James (2002) for example illustrates the procedure of value creation from obtaining critical resources in pharmaceutical industry according to the resource-based view.
For transaction cost theory, firms can determine whether they should do a vertical integration through examining asset specificity, uncertainty, and transaction frequency (Rindfleisch and Heide, 1997). By comparing the opportunity costs and direct transaction costs, companies tend to make an optimal decision on the minimum cost. In this way, firms can maximize their value.
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From the view of knowledge-based theory, scholars suggest the most important resource in a firm is knowledge (Grant, 1996), thus claiming that the primary task of management is to establish the coordination necessary for knowledge integration.
Bresman et al. (2009) also elaborates the value creation process of knowledge-transfer during M&As.
In general, companies take acquisitions based on economic benefits or strategic motivation, while empirical work shows inconsistent evidences of abnormal operating performance for the acquiring firms. Therefore, we derive our Hypothesis 1 to test whether there is abnormal operating performance after the M&As for acquiring firms.
H1: There is abnormal operating performance for acquiring firms compared to non-acquiring counterparts.
2.2 The Real Options Theory and Sequential Mergers and Acquisitions
The real option perspective has been extensively applied in various fields in recent years. For instance, researchers utilize this view into joint venture and indicate that when firms expands into a new market with uncertainty, joint venture is a sort of commonly adopted strategy (Balakrishnan and Koza, 1993; Reuer and Koza, 2000). Joint venture ensures that the acquiring firm does not get involved too deeply in the new market. It is also similar to the concept of buying call option and the toehold investment.
A toehold investment following Zardkoohi’s (2004) view means acquiring firm merely purchases fractional shares of the target firm instead of taking over it at one time.
This acquisition pattern is called sequential acquisition. Further, Xu, Zhou, and Phan (2009) define sequential acquisition with discretion that a block-share transaction is one that acquire 5% or more of share at one time, and the acquirer should own more than 50%
of the target’s shares during the period of research. This sequential mode implies that the acquirer takes over the target firm by purchasing shares partially each time, so they are
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capable of obtaining more information of the acquired firm to eliminate the downside risk of uncertainty and still keeps the infinite profits simultaneously.
Xu et al. (2009) then propose to apply this theory into M&A behavior. They claims that firms can generate value through sequential acquisition mode to reduce the negative effects incurred by asymmetric information because they can become an insider from outsider through the toehold investment. In their research, they provide evidences that private firms relatively lacking of sufficient information concerning the target firms tend to use sequential acquisition as their strategy to take over the target. In doing so, they can create real options to reduce the risk of uncertainty by obtaining more firm-specific information and thus to enjoy a better real option value. Nevertheless, they don’t further discuss whether sequential acquisition or one-time acquisition generates better performance for firms in M&As.
From the view of real options theory, firms should consider taking sequential acquisition instead of one-time deal mainly to eliminate uncertainty (McGrath and Nerkar, 2004; Jiang et al., 2009; Xu et al., 2009). When firms are confronted with the decision on how to acquire a target, the existence of uncertainty may lead to different outcomes. As it is difficult to evaluate the future situation, firms can defer the decision time later until the occasion turns out to be clearer. According to this logic, when firms acquire a target firm, they face three options. First, they can decide whether to acquire the target firms at one time. Second, reject the M&A opportunities. Third, they can take sequential acquisitions which creates a call option on the target firms’ performance.
The last option is also called growth option (Kumar, 2005; Tong and Reuer, 2007) since the value of option is based on the growth opportunity of the target firm. When firms expand their business through M&As, they firstly decide whether to take one-time acquisition or sequential acquisition. If one-time acquisition is chosen, then the outcome
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is irreversible since it makes no change to the situation. On the other hand, if sequential acquisition is chosen, it creates a real option that defers the decision-making procedure until the situation becomes clearer by making a toehold investment. If later the external situations become favorable, the acquirer can exercise the option and benefit from the growth opportunity of the target firm. In contrast, if the condition turns out to be unfavorable such that this investment case is not worthwhile any more, the acquirer still can avoid the enormous sunk cost to exit than one-time acquisition.
In result, the real option theory explains why acquiring firms could enjoy more profit or better performance by sequential acquisition. For one thing, the acquiring firm could delay the acquisition of a target firm until it gains sufficient information to invest further when the target is growing up fast. For another, if the target’s performance deteriorates and the acquirer wants to exit, then the maximum loss would just be equal to the toehold investment, compared to the enormous loss incurred by one-time acquisition. Accordingly, making a toehold investment or taking sequential acquisition is similar to buying a call option for the acquirer, and it can exercise it when the situation is favorable to itself.
Moreover, there is no time limit on the real option compared to the financial options, so it can create more value because of the unlimited time.
Because the real option gives the acquiring firm a choice to reduce the downside risk, we expect firms taking sequential acquisition performs better than one-time acquisition.
Prior studies provide the empirical results to support the superior performance of sequential acquisition (Tong and Reuer, 2007; Jiang et al., 2009; Chang, 2012). Therefore, we derive our Hypothesis 2a based on this logic that there is significant abnormal operating performance for acquiring firms compared to non-acquiring counterparts.
H2a: Abnormal operating performance following sequential acquisitions is better than that following one-time acquisitions.
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Nonetheless, one-time acquisition could still have its advantage over sequential acquisition, thereby we introduce the resource-based theory below to find the benefits one-time acquisition can obtain.
2.3 The Resource-Based Theory and One-time Mergers and Acquisitions
In the strategic management field, the most widely used perspective on M&As is the resource-based theory (Wernerfelt, 1984; Rumelt, 1984; Barney, 1988, Dierrickx & Cool, 1989; Kunc and Morecrodft, 2010). Firm resources consist of all assets, capabilities, organizational process, information, and knowledge. Wernerfelt (1984) indicates that a company is like a broad set of resources and not only comprised of the products it owns.
Das and Teng (2000) also states that the resource-based view puts an emphasis on the analysis of various resources owned by a firm, in that many resources are firm-specific and not perfectly mobile or imitable. Consequently, in order to gain more competitive advantages, which result in abnormal returns or economic rents, firms are willing to sustain its resource heterogeneity.
Barney (1991) believes that enterprises owing heterogeneous resources could achieve better performance, he also claims that there are two assumptions behind the resourced-based theory. Firstly, firms within the industry may be heterogeneous with respect to the resources they control. Secondly, the resources may not be perfectly mobile across firms, and therefore heterogeneity can be durable and enable the firm to attain superior performance for a long period of time. Vorhies, Morgan and Andy (2009) also applies resource-based view to point out that a firm’s operating performance is contingent on the procedure of capability building based on accumulated resources. Terziovski (2010) mentions the relationship between a firm’s innovative practice and the performance among the small and medium firms in manufacturing sectors. Since the resource-based theory is widely used in research, here we follow previous scholars and employ this view
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in our paper to support our ideas.
In addition, Kumar (2005) indicates that the company’s performance will be negatively affected in lights of real options view. In this way, we try to look at another effect which may erode the benefits following sequential acquisitions. Because the firm does always face risk even though without the real option, they should already consider carefully all possible risk they would encounter before they make moves. That is, companies should be well prepared for any possible circumstances. For firms taking the one-time acquisitions, they should be well prepared to face any possible risks. In contrasts, for firms taking the sequential acquisitions, they are either not well-prepared or unable to evaluate possible risks in advance. In consequence, they are destined to have inferior performance by this motivation behind this behavior.
Besides, based on the resource-based theory, firms obtaining more resources can build up and sustain their instinct competitive advantages (Barney, 1991). Through one-time acquisitions, the acquiring firms can obtain all the resources from the target firms, including physical capital resources, human capital resources, and organizational capital resources. So there is a belief that one-time acquisitions allows the firms to obtain more resources than sequential acquisitions. Barney (1991) claims firms with more resources can achieve superior performance by implementing their own strategies and fully exerting their capacities to sustain their competitive advantages. In addition, M&As can bring synergy to the acquirers and realize in future that can improve the firms’ future performance (Chatterjee, 1986: Brush, 1996; Carpon L., 1999). In comparison to firms which take sequential acquisitions without fully controlling the targets, they can merely exert their capabilities with partial resources, thereby leading to inferior performance.
From this considerations, we form Hypothesis 2b that abnormal operating performance following one-time acquisitions may outperform sequential acquisitions.
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H2b: Abnormal operating performance following sequential acquisitions is worse than that of one-time acquisitions.
2.4 Moderating Effect of Organizational Resources on Operating Performance Because different M&A behavior may have different effects on the firm’s acquisitions, we further discuss how organizational resources can moderate or affect the firm’s post-takeover performance before we continue to report the empirical results.
Bourgeois (1981) states that the capability to adapt to dramatic changes in the environment is frequently linked to the absorption mechanism termed organizational slack. According to Bourgeois’ definition, organizational slack is a cushion of actual or potential resources available for a company to accommodate itself to internal pressure to external changes. Firms with more slacks are easier to make a change caused by the environment.
Slack resources in an organization play important roles, it helps to resolve conflicts
Slack resources in an organization play important roles, it helps to resolve conflicts