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IBMECRJ

Ttulo: NewEvidenceandPerspectivesonMergers.Por:Andrade,Gregor,Mitchell,
Mark,Stafford,Erik,JournalofEconomicPerspectives,08953309,
Spring2001,Vol.15,Nmero2
Basededados: BusinessSourceComplete

NEWEVIDENCEANDPERSPECTIVESONMERGERS

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Empirical research on mergers and acquisitions has revealed a great deal about their trends
and characteristics over the last century. For example, a profusion of event studies has
demonstratedthatmergersseemtocreateshareholdervalue,withmostofthegainsaccruing
to the target company. This paper will provide further evidence on these questions, updating
ourdatabaseoffactsforthe1990s.
But on the issue of why mergers occur, research success has been more limited. Economic
theory has provided many possible reasons for why mergers might occur: efficiencyrelated
reasons that often involve economies of scale or other "synergies" attempts to create market
power, perhaps by forming monopolies or oligopolies market discipline, as in the case of the
removal of incompetent target management selfserving attempts by acquirer management to
"overexpand"andotheragencycostsandtotakeadvantageofopportunitiesfordiversification,
likebyexploitinginternalcapitalmarketsandmanagingriskforundiversifiedmanagers.
Mostofthesetheorieshavebeenfoundtoexplainsomeofthemergersoverthelastcentury,
andthusareclearlyrelevanttoacomprehensiveunderstandingofwhatdrivesacquisitions.In
addition,someofthesereasonsformergersappeartobemorerelevantincertaintimeperiods.
For example, antitrust laws and active enforcement have made merger for market power
difficulttoachievesincethe1940s.Theheydayofdiversificationmergerswasinthe1960s,and
there is evidence to suggest many of those mergers were ultimately failures. Mergers as
instruments for market discipline do not seem to appear on the radar until the 1980s, but
although it is customary to label the 1980s as the era of hostile takeovers, only 14 percent of
dealsinthatdecadeinvolvedhostileparties.
A recent strand of the literature, exemplified by Mitchell and Mulherin (1996), has tried to
addresstheissueofwhymergersoccurbybuildingupfromthetwomostconsistentempirical
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featuresofmerger activity over the last century: 1) mergers occur in waves and 2) within a
wave,mergersstronglyclusterbyindustry.Thesefeaturessuggestthatmergersmightoccur
asareactiontounexpectedshockstoindustrystructure.Webelievethisarenaisapotentially
fruitful one to explore from both a theoretical and empirical point of view. It also seems to
correspond to the intuition of practitioners and analysts that industries tend to restructure and
consolidate in concentrated periods of time, that these changes occur suddenly, and that they
are hard to predict. However, identifying industry shocks and documenting their effect is
challenging.
Inthispaper,weprovideevidencethatmergeractivityinthe1990s,asinpreviousdecades,
stronglyclustersbyindustry.Furthermore,weshowthatoneparticularkindofindustryshock,
deregulation, while important in previous periods, becomes a dominant factor in merger and
acquisitionactivityafterthelate1980sandaccountsfornearlyhalfofthemergeractivitysince
then. In fact, we can say without exaggeration or hyperbole that in explaining the causes of
mergersandacquisitions,the1990swerethe"decadeofderegulation."
Ofcourse,intheend,knowingthatindustryshockscanexplainalargeportionofmergeractivity
doesnotreallyhelpclarifythemechanisminvolved,whichbringsustotheissuesweknowleast
about: namely, what are the longterm effects of mergers, and what makes some successful
and others not. Here, empirical economists, and we include ourselves in this group, have had
very little to say. We hope that over the next decade merger research will move beyond the
basic issue of measuring and assigning gains and losses to tackle the more fundamental
questionofhowmergersactuallycreateordestroyvalue.
Mergersinthe1990s:What'sNew?
Many of the results discussed here have been reported by other authors, using different
samples,andovervarioustimeperiods.Inthispaper,wedocumentmerger activity using the
stock database from the Center for Research in Security Prices (CRSP) at the University of
Chicago. This database contains pricing information for all firms listed in the New York Stock
Exchange (NYSE), American Stock Exchange (AMEX), and Nasdaq. We focus on mergers
whereboththeacquirerandthetargetarepubliclytradedU.S.basedfirms.
Figure1displaystwodifferentmeasuresofannualmergeractivity.Thedottedlinerepresents
the number of firms acquired during the year expressed as a fraction of the beginningofyear
number of firms in CRSP. The solid line gives a sense for the values involved, obtained by
dividing the aggregate dollar value of mergers over the year by the total beginningofyear
marketcapitalizationofthefirmslistedonCRSP.[1]Theevidenceisentirelyconsistentwiththe
wellknown view that there have been three major waves of takeover activity since the early
1960s. Interestingly, the 1960s wave contained many more deals, relative to the number of
publicly available targets, than the 1980s. However in dollar terms, the 1980s were far more
important, as large multibillion dollar deals became common. On a valueweighted basis, the
1980sweretrulyaperiodofmassiveassetreallocationviamerger,andasreportedbyMitchell
and Mulherin (1996), nearly half of all major U.S. corporations received a takeover offer. It is
astounding that the merger and acquisition activity in the 1990s seems to be even more
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dramaticandwidespread,withnumberofdealscomparabletothe1960s,andvaluessimilarto
the1980s.[2]
Fortheremainderofthepaper,wewillfocusonthe26yearsbeginningin1973,sincethatisthe
periodduringwhichNasdaqfirmsarefullyincorporatedintoCRSP,aneventwhichdrastically
altered the size and composition of the sample. This results in about 4,300 completed deals.
Table 1 reports key descriptive statistics and characteristics for our merger sample, broken
downbydecade.[3]
TheevidenceinTable1suggeststhatmergersinthe1980sand1990saredifferentinmany
ways.Thefirstkeydistinctionistheoverwhelminguseofstockasamethodofpaymentduring
thelatterdecade.About70percentofalldealsinthe1990sinvolvedstockcompensation,with
58percententirelystockfinanced.Thesenumbersareapproximately50percentmorethanin
the1980s.
Perhaps related to the predominance of stock financing, note the virtual disappearance of
hostilityinthetakeovermarket.Wedefineabidashostileifthetargetcompanypubliclyrejects
it,oriftheacquirerdescribesitasunsolicitedandunfriendly.Only4percentoftransactionsin
the1990sinvolvedahostilebidatanypoint,comparedto14percentinthe1980s,andahostile
bidder acquired less than 3 percent of targets. [ 4] Consistent with this more "friendly"
atmosphere,theaveragetransactioninthe1990sinvolvedonlyonebidder,and1.2roundsof
bidding,farlessthanduringthe1980s.
The evidence for the 1980s by itself is interesting, because it suggests that the hostility of
takeoveractivityduringthattimewaslessseverethangenerallybelieved.MitchellandMulherin
(1996) report that 23 percent of the firms in their sample receive a hostile bid at some point
duringthe1980showever,theirsampleonlyincludesfirmslistedintheValueLineInvestment
Survey,whicharegenerallylarger,betterknowncompanies.Duringthesameperiod,only14
percent of the firms in our sample receive a hostile offer. Since we include all publicly traded
firms,thecontrastinthesetworesultssuggeststhathostileactivitywaspracticallynonexistent
amongthesmaller,lesserknowncompanies.
Finally, the 1990s continue a trend, begun in the 1970s, of an everincreasing percentage of
mergers where both parties are in the same industry (defined at the 2digit SIC code level),
now nearly half. The picture of mergers in the 1990s that emerges is one where merging
parties,oftenincloselyrelatedindustries,negotiateafriendlystockswap.
Of the recent empirical findings highlighted in the literature, one of the most interesting is the
presence of industry clustering in merger activity. Mitchell and Mulherin (1996) document
industry clustering by target firms for the 1980s and Andrade and Stafford (1999) document
industry clustering by acquiring firms during the 19701994 period[ 5] Although merger and
acquisition activity, as discussed above, occurs in readily identifiable waves over time, these
wavesarenotalike.Infact,theidentityoftheindustriesthatmakeupeachmergerboomvaries
tremendously. A simple way to see that is to compare the level of merger activity in each
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industry over time. If we rank industries in each decade by the market values of all acquired
firms, and then correlate these ranking across decades, we find that the correlations are
negligiblethat is, industries that exhibit high levels of merger activity in one decade, are no
morelikelytodosoinotherdecades.AsTable2illustrates,thereisnooverlapbetweenthetop
fiveindustries,rankedbymergervalues,ofthe1980sand1990s.
Ifmergerscomeinwaves,buteachwaveisdifferentintermsofindustrycomposition,thena
significant portion of merger activity might be due to industrylevel shocks. Industries react to
theseshocksbyrestructuring,oftenviamerger.Theseshocksareunexpected,whichexplains
why industrylevel takeover activity is concentrated in time, and is different over time, which
accounts for the variation in industry composition for each wave. Examples of shocks include:
technological innovations, which can create excess capacity and the need for industry
consolidationsupplyshocks,suchasoilpricesandderegulation.[6]
The view that merger activity is the result of industrylevel shocks is not new. Among others,
Gort (1969),Jensen (1986), Morck, Shleifer and Vishny (1988), and Jensen (1993) all
hypothesizeasmuch.However,recentlytherehasbeenevidencesuccessfullytyingmergers
tospecificshocks.MitchellandMulherin(1996)showthatderegulation,oilpriceshocks,foreign
competition,andfinancialinnovationscanexplainasignificantportionoftakeoveractivityinthe
1980s.IntheintroductiontoMergersandProductivity,acollectionofindepthcasestudiesof
mergers, editor Steven Kaplan (2000) concludes, "a general pattern emerges from these
studies. It is striking that most of the mergers and acquisitions were associated with
technologicalorregulatoryshocks."
Oftheshockslistedabove,deregulationisanidealcandidateforanalysis.First,itcreatesnew
investmentopportunitiesfortheindustry.Second,itpotentiallyremoveslongstandingbarriersto
mergingandconsolidating,whichmighthavekepttheindustryartificiallydispersed.Finally,itis
fairly welldefined in time and in terms of parties affected, so empirically we know where and
whentolook.
We classify the following industries as having undergone substantial deregulation since 1973:
airlines (1978), broadcasting (1984 and 1996), entertainment (1984), natural gas (1978),
trucking (1980), banks and thrifts (1994), utilities (1992) and telecommunications (1996). We
defineatenyearperiodaroundeachoftheseevents(threeyearsbeforetosixyearsafter)asa
"deregulationwindow."Figure2displays,foreachyear,thepercentageoftotalmergeractivity
representedbymergersinindustriesinthederegulationwindow.Duringmostofthe1980s,this
percentagehoversaround1015percent.After1988,however,deregulatedindustriesaccount
fornearlyhalfofallannualdealvolume,onaverage.[7]Thisisconsistentwiththeevidencein
Table2thatbankingandmedia/telecommunicationsaretwoofthemostactiveindustriesinthe
1990s.
Itisclearthatderegulationwasakeydriverofmergeractivityoverthelasttenyears.Whether
rightly or wronglyand the jury is still out on the efficiency benefits and value enhancements
brought about in these industriesthe fact is that deregulation precipitated widespread
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consolidationandrestructuringofafewindustriesinthe1990s,frequentlyaccomplishedthrough
merger.
In our view, the industry shock explanation for mergers has added substantially to our
understandingofmergers,notsomuchhowmergerscreatevalue,butratherwhyandwhen
they occur. The results presented here update and expand the evidence on industry shocks
withspecificemphasisonderegulatoryevents.[8]Futureempiricalresearchonmergersshould
attempttocontrolforindustryshocks.
WinnersandLosersintheMergerGame
Mergers represent massive reallocations of resources within the economy, both within and
acrossindustries.In1995,thevalueofmergersandacquisitionsequaled5percentofGDPand
wasequivalentto48percentofnonresidentialgrossinvestment.Fromthefirm'sperspective,
mergersrepresentquiteextraordinaryevents,oftenenablingafirmtodoubleitssizeinamatter
ofmonths.Consequently,measuringvaluecreation(ordestruction)resultingfrommergersand
determininghowthisincrementalvalueisdistributedamongmergerparticipantsaretwoofthe
centralobjectivesinfinanceandindustrialorganizationmergerresearch.
StockMarketReactiontoMergerAnnouncements
The most statistically reliable evidence on whether mergers create value for shareholders
comes from traditional shortwindow event studies, where the average abnormal stock market
reaction at merger announcement is used as a gauge of value creation or destruction. In a
capital market that is efficient with respect to public information, stock prices quickly adjust
followingamerger announcement, incorporating any expected value changes. Moreover, the
entire wealth effect of the merger should be incorporated into stock prices by the time
uncertainty is resolved, namely, by merger completion. Therefore, two commonly used event
windowsarethethreedaysimmediatelysurroundingthemerger announcementthat is, from
one day before to one day after the announcementand a longer window beginning several
dayspriortotheannouncementandendingatthecloseofthemerger.
Table3displaysannouncementperiodabnormalreturnsforbothacquirersandtargets,aswell
asfortheacquirerandtargetcombined.Theaverageannouncementperiodabnormalreturns
overthethreedayeventwindowforthetargetandacquirercombinedarefairlysimilaracross
decades,rangingfrom1.4percentto2.6percent,andaveraging1.8percentoverallfor3,688
completed mergers. In addition, the combined average abnormal returns over this event
windowarereliablypositive,suggestingthatmergersdocreateshareholdervalueonaverage.
Whentheeventwindowisexpandedtobegin20dayspriortothemergerannouncementand
endonthemergerclosingdate,thecombinedaverageannouncementperiodabnormalreturn
is essentially identical at 1.9 percent. However, statistical precision is considerably reduced as
theeventwindowislengthenedtoanaverageof142days,andthisestimatecannotbereliably
distinguishedfromzero.
Target firm shareholders are clearly winners in merger transactions. The average threeday
abnormalreturnfortargetfirmsis16percent,whichrisesto24percentoverthelongerevent
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window.Bothoftheseestimatesarestatisticallysignificantatthe1percentlevel.In1998,the
median equity market value for target firms was $230 million, such that a 16 percent
announcement period abnormal return corresponds to $37 million for target firm shareholders
over a threeday period. Another benchmark to gauge the magnitude of this return is the
averageannualreturnforallpubliclytradedfirms,whichisaround12percent.Inotherwords,
over a threeday period, target firm shareholders realize a return equivalent to what a
shareholderwouldnormallyexpecttoreceiveovera16monthperiod.
The average announcement period abnormal return estimate for target firms is remarkably
stableacrossdecades.Thisisinterestinginthelightoftheevidenceonclusteringofmerger
activity.Eachdecadeisassociatedwithmergeractivityconcentratedindifferentindustries,but
thetargetfirmsconsistentlyhaveabnormalreturnsof16percentintheannouncementperiod.
Together,thesetwoobservationssuggestthatmergerpremiaarefairlysimilaracrossdifferent
typesofmergertransactions.
Theevidenceonvaluecreationforacquiringfirmshareholdersisnotsoclearcut.Theaverage
threedayabnormalreturnforacquirersis0.7percent,andoverthelongereventwindow,the
averageacquiringfirmabnormalreturnis3.8percent,neitherofwhichisstatisticallysignificant
atconventionallevels.Althoughtheestimatesarenegative,theyarenotreliablyso.Thus,itis
difficult to claim that acquiring firm shareholders are losers in merger transactions, but they
clearlyarenotbigwinnerslikethetargetfirmshareholders.
The results in Table 3 are consistent with results presented in earlier summary papers by
Jensen and Ruback (1983) and Jarrell, Brickley and Netter (1988). Mergers seem to create
value for shareholders overall, but the announcementperiod gains from mergers accrue
entirely to the target firm shareholders. In fact, acquiring firm shareholders appear to come
dangerously close to actually subsidizing these transactions. However, the picture is not quite
complete.Thefifilsampleresultshideanimportantdistinctionbasedonthefinancingofthese
transactions. In particular, mergers financed with stock, at least partially, have different value
effectsfrommergersthatarefinancedwithoutanystock.
From the acquiring firm's perspective, stockfinanced mergers can be viewed as two
simultaneous transactions: a merger and an equity issue. On average, equity issues are
associated with reliably negative abnormal returns of around 2 to 3 percent during the few
dayssurroundingtheannouncement.Manymodelshavebeendevelopedtoexplainthisfinding,
mostlyfocusingoninformationdifferencesbetweenmanagersandoutsideinvestors(Myersand
Majluf, 1984). The basic idea is that managers are more likely to issue equity when they
perceive that it is overvalued by the stock market than when undervalued. Consequently,
investors observing an equity issue bid down the stock price. Therefore, it is important to
separate the stockfinanced mergers from the others before making final judgement on the
valueeffectsforshareholders,especiallyfortheacquiringfirms.
Table 4 displays average announcement period abnormal returns for subsamples split on the
basis of whether any stock was used to finance the merger transaction. Interestingly, the
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negativeannouncementperiodstockmarketreactionforacquiringfirmsislimitedtothosethat
finance the merger with stock. Acquiring firms that use at least some stock to finance their
acquisition have reliably negative threeday average abnormal returns of 1.5 percent, while
acquirersthatabstainfromequityfinancinghaveaverageabnormalreturnsof0.4percentwhich
are indistinguishable from zero. These findings are consistent with the notion that the
announcement period reaction for the acquirer to a stockfinanced merger represents a
combinationofamergerannouncementandanequityissueannouncement.
Target firm shareholders also do better when there is no equity financing. The threeday
averageabnormalreturnfortargetfirmsis13percentforstockfinancedmergersandjustover
20percentformergersfinancedwithoutstock.Interestingly,thisisnotmerelyamanifestationof
largerdealshavingsmallerpremiaandagreatertendencytobestockfinanced.Aftercontrolling
for deal size, this difference remains (11.3 percent for large stock deals and 17.8 percent for
largenonstockdeals).Financingalsohasasignificantimpactoninferencesaboutoverallvalue
creation from mergers. The combined average abnormal returns for stockfinanced mergers
arezero,suggestingthatthissubsetofmergersdonotincreaseoverallshareholdervalue.On
the other hand, the combined threeday abnormal returns for mergers financed without any
stockarereliablypositiveat3.6percent.
Basedontheannouncementperiodstockmarketresponse,weconcludethatmergers create
valueonbehalfoftheshareholdersofthecombinedfirms.
LongTermAbnormalReturns
Formanyyears,thetraditionalwisdomwasthattheannouncementperiodstockpricereaction
fully impounds the information effects of mergers. However, several recent longterm event
studies measuring negative abnormal returns over the three to five years following merger
completion cast doubt on the interpretation of traditional shortwindow event study findings.
According to these studies, investors systematically fail to assess quickly the full impact of
corporateannouncements,withtheimplicationthatinferencesbasedonannouncementperiod
event windows are flawed, particularly those attempting to document the wealth effect of the
event.Infact,someauthorsfindthatthelongtermnegativedriftinacquiringfirmstockprices
overwhelmsthepositivecombinedstockpricereactionatannouncement,makingthenetwealth
effectnegative.
The most dramatic longterm abnormal performance comes from certain subsamples of
acquiringfirms.Forexample,LoughranandVijh(1997)separatelycalculatelongtermabnormal
returns for acquiring firms using stock financing and those paying with cash over the period
19701989.Theyfindthatacquiringfirmsusingstockfinancinghaveabnormalreturnsof24.2
percentoverthefiveyearperiodafterthemerger,whereastheabnormalreturnis18.5percent
forcashmergers.
Anothergroupingthatproducesalargedifferenceinlongtermabnormalreturnsisbasedonthe
booktomarketequityratio.Firmsclassifiedonthebasisofhighbooktomarketarecommonly
referredtoas"value"firms,andtendtohavehigherreturnsonaverage.Firmsidentifiedaslow
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booktomarketarereferredtoas"growth"or"glamour"firms,andhaverelativelylowreturnson
average. Interpretations of these findings vary. For example, Fama and French (1992, 1993)
arguethattherelativelyhighreturnsofvaluefirmsareduetoincreasedrisk,perhapsrelatedto
distress.Ontheotherhand,Lakonishok,ShleiferandVishny(1994)arguethatthedifferential
returnsofvalueandgrowthstocksarenotrelatedtorisk,butinsteadarisebecauseinvestors
mistakenly estimate future performance by extrapolating from past performance. Using the
value/growth distinction, Rau and Vermaelen (1998) calculate threeyear abnormal returns of
17.3 percent for glamour acquirers and 7.6 percent for value acquirers over the period 1980
1991.
Thereareanumberofmethodologicalconcernswithlongtermeventstudies(BarberandLyon,
1997KothariandWarner,1997Fama,1998MitchellandStafford,2000Brav,2000).These
papers question every aspect of the longterm event studies, from the calculation of the point
estimatestotheassumptionsrequiredtoassessstatisticalsignificance.Thebasicconcernstems
fromalltestsoflongtermabnormalperformancebeingjointtestsofstockmarketefficiencyand
amodelofmarketequilibrium(Fama,1970).Thisproblemisnotamajoroneforshortwindow
eventstudieswherethreedayexpectedreturnsarevirtuallyzeroregardlessofwhatmodelof
expectedreturnsisused.Announcementperiodreturnsof1to3percentoverthreedaysare
easy to reject as normal returns when the expected return is on the order of 0.05 percent.
However,themodelofexpectedreturnsbecomesincreasinglyimportantastheholdingperiodis
lengthened, becoming crucial for multiyear horizons. Threeyear expected returns can easily
range from 30 percent to 65 percent, depending on the model used, making it very difficult to
determinewhetheranabnormalreturnof15percentisstatisticallysignificant.Thebottomlineis
that if longterm expected returns can only be roughly estimated, then estimates of longterm
abnormalreturnsarenecessarilyimprecise.
An additional statistical concern with many longterm event studies is that the test statistics
assumethatabnormalreturnsareindependentacrossfirms.However,majorcorporateactions
like mergers are not random events, and thus event samples are unlikely to consist of
independent observations. ~&s noted earlier, mergers cluster through time by industry. This
clustering leads to positive crosscorrelation of abnormal returns, which in turn means that test
statisticsthatassumeindependenceareseverelyoverstated.
Inadditiontoquestioningthestatisticalreliabilityoflongtermeventstudies,MitchellandStafford
(2000) provide estimates of longterm abnormal returns that are robust to the most common
statistical problems, including crosssectional dependence. Table 5 displays threeyear post
mergerabnormalreturnsfor2,068acquiringfirms.Theabnormalreturnsarecalculatedforboth
equal and valueweight portfolios of acquiring firms in the threeyears following the merger
completion. First, the abnormal return estimates shown in Table 5 are considerably closer to
zero than in most studies that use samples covering shorter time periods, and the dramatic
differences in performance based on financing and the value/ growth distinction are greatly
reduced. Second, significant abnormal returns are only found for the equalweight portfolios,
suggesting that postmerger abnormal stock price performance is limited to the smallest
acquirers.Infact,almostallreliableabnormalstockpriceperformancecomesfromfirmsinthe
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smallestquintileoffirms.FamaandFrench(1993)reportthatthefirmsinthesmallestquintile
(based on NYSE breakpoints) account for only 2.8 percent of the value of the CRSP value
weightstockmarket,onaverage.Althoughthisrepresentsalargenumberoffirms,itisnotclear
how economically important this portion of the market is for assessing overall stock market
efficiency.
The longrun literature on abnormal stock price performance has added to the profession's
knowledge of market efficiency and empirical asset pricing. This literature has not focused on
longterm performance following mergers, per se, but rather has examined all types of
corporate events ranging from initial public offering to stock splits. Given the serious
methodologicalconcernswiththelongrunempiricalliteratureasoutlinedabove,wearereluctant
to accept the results at face value. With respect to mergers, it is our view that the longrun
abnormal performance results do not change our priors that result from the announcement
periodanalyses,namely,thatmergerscreatevalueforthestockholdersofthecombinedfirms.
PreandPostmergerProfitability
Operating performance studies attempt to identify the sources of gains from mergers and to
determinewhethertheexpectedgainsatannouncementareeveractuallyrealized.Ifmergers
trulycreatevalueforshareholders,thegainsshouldeventuallyshowupinthefirms'cashflows.
Thesestudiesgenerallyfocusonaccountingmeasuresofprofitability,suchasreturnonassets
andoperatingmargins.RavenscraftandScherer(1989)andHealy,PalepuandRuback(1992)
are two operating performance studies that have been particularly influential in reinforcing
perceptions about the gains to acquiring firms. These two papers reach different conclusions
about gains from mergers. However, each study has data limitations which raise concerns
aboutthegeneralityofthefindings.
RavenscraftandScherer(1989)examinetargetfirmprofitabilityovertheperiod1975to1977
using Line of Business data collected by the Federal Trade Commission. The FTC collected
data for 471 firms from 1950 to 1976 by the business segments in which the firms operated.
Ravenscraft and Scherer find that the target lines of business suffer a loss in profitability
following the merger. They conclude that mergers destroy value on average, which directly
contradictstheconclusiondrawnfromtheannouncementperiodstockmarketreaction.
Healy, Palepu and Ruback (1992) examine postmerger operating performance for the 50
largestmergersbetween1979and1984.Inparticular,theyanalyzetheoperatingperformance
for the combined firm relative to the industry median. They find that merged firms experience
improvements in asset productivity, leading to higher operating cash flows relative to their
industry peers. Interestingly, their results show that the operating cash flows of merged firms
actuallydropfromtheirpremergerlevelonaverage,butthatthenonmergingfirmsinthesame
industry drop considerably more. Thus, the postmerger operating performance improves
relativetotheindustrybenchmark.
Therecentevidence on industry clustering of merger activity is important for interpreting the
findingsofoperatingperformancestudies.First,selectinganappropriateexpectedperformance
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benchmark in the absence of a merger is crucial. Simply using the same firm's premerger
performance will be unsatisfying if the merger transaction comes in response to an industry
shock that changes the prospects for a meaningful fraction of the firms in the industry. An
industrybasedbenchmarkasemployedbyHealy,PalepuandRuback(1992)willhelpabsorb
thiseffect.Second,thetendencyformergeractivitytoclusterthroughtimebyindustrymeans
thatashortsampleperiodwillcontainobservationsfromonlyafewindustries,makingitdifficult
to generalize from these samples. Finally, if there is a common shock that induces merger
activityataparticularpointintime,thereisnoreasonforittobelimitedtojustoneindustryorto
affectallfirmsinanindustry.Therefore,controllingforindustrymaynotbesufficienttoaccount
forallcrosssectionalcorrelation.Asamplespanningalongertimeperiodallowsforstatistical
techniquesthatarebetterabletoaccountforcrosssectionaldependence.
Table6reportsresultsfromatimeseriesofannualcrosssectionsmethodology,whichissimilar
in spirit to one employed by Fama and MacBeth (1973). This methodology requires a longer
time series, but the test statistics account for crosssectional dependence in performance
measures, and should therefore be immune to the effects of industry clustering of merger
activity.Thesampleincludesroughly2,000mergersfrom1973to1998,forwhichaccounting
dataareavailableonCompustat.
ThefirstrowofTable6replicatesthemainfindingsofHealy,PalepuandRuback(1992)that
postmergeroperatingmargins(cashflowtosales)areonaverageimprovedrelativetoindustry
benchmarks. In particular, we report the average abnormal operating performance, where we
measure abnormal operating performance as the difference between the combined firm's
operating margin and the corresponding industry median operating margin.[ 9] The results
suggestthatthecombinedtargetandacquireroperatingperformanceisstrongrelativetotheir
industrypeerspriortothemerger,andimprovesslightlysubsequenttothemergertransaction.
ThesecondrowofTable6reportsresultsfromaregressionanalysisinwhichweregressthe
postmergerabnormaloperatingperformancemeasureonthepremergerabnormaloperating
performance measure.[ 10] The intercept measures the average postmerger abnormal
operating performance after controlling for the persistence of this measure through time. On
average,thereisanimprovementinoperatingmarginsfollowingthemerger,ontheorderof1
percent, which is statistically significant at the 1 percent level.[ 11] The improvement in post
merger cash flow performance is consistent with the positive announcementperiod stock
marketreturnstothecombinedtargetandacquirerfirms.
WhereWeStand
Earlier review papers of the evidenceonmergers by Jensen and Ruback (1983) and in this
journalbyJarrell,BrickleyandNetter(1988)surveythepre1980and1980sempiricalliterature,
respectively, and conclude that mergers create value for the stockholders of the combined
firms,withthemajorityofthegainsaccruingtothestockholdersofthetarget.Bothstudiesbase
theirconclusionontheannouncementperiodstockpricereactiontomergers. Our analysis of
theimmediatestockmarketresponsetomorethan4,000mergerscompletedduringthe1973
1998concurswiththesepriorreviews.
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AtthetimeoftheJensenandRuback(1983)paper,theempiricalliteraturelargelyconsistedof
computingtheaveragereturnstomergerannouncements.Bythemidtolate1980s,merger
research as summarized by Jarrell, Brickley and Netter (1988) also studied the redistribution
aspects of mergers. Specifically, were the gains to shareholders simply reflective of wealth
transfersfrombondholders,employees,orcommunities?Jarrell,BrickleyandNetterarguethat
thereisvirtuallynoempiricalevidencethatgainstoshareholdersareduetolossesfromother
stakeholders. They therefore conclude that the gains to shareholders must be real economic
gainsviatheefficientrearrangementofresources.Weareinclinedtodefendthetraditionalview
thatmergers improve efficiency and that the gains to shareholders at merger announcement
accurately reflect improved expectations of future cash flow performance. But the conclusion
mustbedefendedfromseveralrecentchallenges.
Afirstchallengeistheresearchfindingsofanegativedriftinacquiringfirmstockpricesfollowing
merger transactions, which would imply that the gains from mergers are overstated or
nonexistent. As noted in our earlier discussion, we are very skeptical of these studies, which
havebeenshowntobefraughtwithmethodologicalproblems.Thefundamentalproblemisthat
to measure longterm abnormal returns reliably, one must first be able to measure longterm
expectedreturnspreciselyandnoonehasprovidedaconvincingwaytodothis.Furthermore,
the evidence on longterm returns conflicts with the results, reported here, that mergers
improve the longterm cash flow performance of the merging parties, relative to their industry
peers.
A second challenge is that the underlying sources of the gains from mergers have not been
identified. Here, the large sample nature of most studies, which tend to combine transactions
withdifferentmotivations,andtheinherentnoisinessoftheaccountingdata,havemadeitnearly
impossible for traditional research methods to address the issue. The positive effect of the
mergerisrecognizedbythestockmarket,butitisdifficultforeconomicresearcherstoidentify
the sources of the gains with their much coarser information sets. In an attempt to overcome
theselimitationsandtounderstandbetterthesourcesofvaluecreationanddestructionarising
from mergers, there have recently been several studies that try to improve on the evidence
arisingfromaccountingbaseddatabyexaminingmoredetailedinformation.
Onesetofstudieshaveanalyzedtotalfactorefficiencyandotherproductivitychangesfollowing
mergers, using plantlevel input and output data from the Longitudinal Research Database at
the Bureau of the Census. The general conclusion is that ownership changes are positively
relatedtoproductivityimprovementsattheplantlevel,buttherelationshipisnotpresentinfirm
level data. For example, McGuckin and Nguyen (1995) find that recently acquired plants
experience productivity improvements, while the acquirer's existing plants suffer productivity
losses, making the net change for the acquiring firm essentially zero. Schoar (2000) confirms
thisresult.
Along these same lines, in 1996, the NBER commissioned a group of academic researchers
headedbyStevenKaplantoconductindepthcasestudiesofasmallnumberofmergers.The
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studieswerepublishedinMergersandProductivity(Kaplan,2000).Thepurposeoftheclinical
researchwastofillinthegapsleftoutbythepriorlargesamplestockreturnsandaccounting
performance studies. The studies revealed a richness in the economic data surrounding
mergersthatcannotbecapturedbylargesamplestudies.Atthesametime,thesestudiesdid
not generate substantial insights into exactly how mergers create value, and thus do not
satisfactoryfilltheresearchgapasintended.Thisareaofinvestigationiswideopen,spanning
thefieldsofcorporatefinance,industrialorganization,organizations,andstrategy.
Athirdchallengetotheclaimthatmergers create value stems from the finding that all of the
gainsfrommergers seem to accrue to the target firm shareholders. We would like to believe
that in an efficient economy, there would be a direct link between causes and effects, that
mergers would happen for the right reasons, and that their effects would be, on average, as
expected by the parties during negotiations. However, the fact that mergers do not seem to
benefitacquirersprovidesreasontoworryaboutthisanalysis.
Partoftheissueheremaybethatanacquiringfirmcanseekamergerforamixofreasons.
Manyfirmsmentionmergersastheirmainstrategictoolforgrowthandsuccess,andpointto
possibleeconomiesofscale,synergies,andgreaterefficiencyinmanagingassets.Alternatively,
there is the somewhat contradictory evidence that mergers can be evidence of empire
building behavior by managers. If mergers could be sorted by true underlying motivations, it
may be that those which are undertaken for good reasons do benefit acquirers, but in the
averagestatistics,thesearecancelledoutbymergersundertakenforlessbenignreasons.[12]
Furthermore, the mere presence of competing bidders (or the potential for them to appear)
could allow targets to extract full value from the eventual winner. Of course this cannot fully
explain why acquirers rarely gain, since many contests, particularly in the 1990s, only feature
onebidder.Also,ifthetermsynergyistohaveanymeaninginamergercontext,thenitshould
imply that there is a common gain from uniquely joining the target and bidder, a benefit that
cannotbeappropriatedbycompetingacquirers.Inthatcase,itisstillpuzzlingthatinthedata,
targetsappeartokeepallsynergisticbenefitsofthepairingtothemselves.
Thehardesttaskhereistomakeanargumentforwhattheabnormalreturnsforacquiringfirms
should be. An abnormal return reflects the unexpected future economic rents arising from the
transaction. In other words, an abnormal return of zero reflects a fair rate of return on the
merger investment from the acquirer's point of view. Empirical studies of other investment
decisions,suchasresearchanddevelopment,capitalexpenditures,jointventures,andproduct
introductions, typically report very small (less than 1 percent) abnormal returns at the
announcement of the investment decisions.[ 13] In the light of such evidence, the
announcementperiodabnormalreturnsof0.4percentfornonstockacquirerslookprettymuch
thesameasthoseforothertypesofinvestments.Ultimately,whattheevidenceshowsisthatit
ishardforfirmstoconsistentlymakeinvestmentdecisionsthatearnlargeeconomicrents,which
perhaps should not be too surprising in a competitive economy with a fairly efficient capital
market.
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Acknowledgements
TheauthorsthankTimothyTaylor,JudyChevalier,J.BradfordDeLong,andMichaelWaldman
forhelpfulcomments.
Footnotes
[1]BothmeasuresareexpressedaspercentagesoftotalCRSPfirms,tocontrolfortheoverall
growthinthenumberoffirmslistedoverthesampleperiod.
[2]Ourdataonlygoesto1998.However,thewavehascontinued,andinfact,1999isreported
tobethelargestyeareverforU.S.mergers,onatotaldollarvaluebasis.
[3]SeeSchwert(2000)forsimilardescriptivestatisticsandcharacteristicsformergers during
19751996involvingexchangelisted(NYSEandAMEX)targets.
[4]Schwert(2000)questionsthebifurcationofmergersintofriendlyandhostilecategories.He
performs numerous analyses to show that hostile deals, as described in the press, are no
different from friendly deals in economic terms, that is, based on accounting and stock
performancedata.
[5]Thereisalsoevidenceofclusteringinearlierperiods.SeeNelson(1959)forevidence on
thefirsthalfofthetwentiethcentury,andGort(1969)forthe1950s.
[6]Anotherpotentialexplanationforwhymergersoccurinwavesandclusterbyindustrymight
bethatmergersareexamplesof"informationcascades"(Bikchandanietal.,1992).Thebasic
ideaisthatanaction,inthiscaseamerger,informsagentsinsimilarcircumstancesaboutthe
profitabilityofsimilaractions,inthiscaseothermergers.Hence,oncethereisafirstmergerin
an industry, the likelihood of other similar mergers occurring goes up, which would explain
clustering. However, the theory says nothing about what precipitates that first "triggering"
merger in an industry. As discussed later, there is strong evidence, both in this paper and
others, that merger activity is related to specific industry shocks, such as deregulation. We
therefore believe that the industry shocks better account for the fundamental forces behind
mergeractivity.
[7]Perourreadingsofindustryanalystreports,deregulationshocksoftenextendwellbeyond
the direct industries targeted. We did not, however, attempt to measure the indirect impact of
deregulationshocksonrelatedindustries.
[8]Also,seeMulherinandBoone(2000)forananalysisofindustryshocksandmergersinthe
1990s.
[9]Thepremergerunitofobservationisthesalesweightedaverageoftheacquirerandtarget
abnormal operating performance measures. Following the merger, the unit of observation is
simplytheacquirer.
[10] This analysis also uses the Fama and MacBeth (1973) timeseries of crosssections
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methodology.
[11] The 1 percent increase in operating performance may be a lower bound on the gains to
merger. Following Mitchell and Mulherin (1996) and Andrade and Stafford (1999), we have
shown that industry shocks arc a primary source of takeover activity. To the extent that the
benchmark firms are also undertaking valueenhancing mergers or otherwise restructuring
internallyinresponsetoindustryshocks,themeasuredchangeinoperatingperformancewillbe
biaseddown.
[12]Forexample,MitchellandLehn(1990)provideempiricalevidencethattherearebothgood
and bad mergers from the viewpoint of the stockholders of the acquirer, where the bad
acquirersareeventuallypunishedinthetakeovermarketitself.
[13]SeeMcConnellandMuscarella(1985)forevidenceoncapitalexpenditureannouncements
andChan,MartinandKensinger(1990)onR&Dinvestments.
Table1:CharacteristicsandDescriptiveStatisticsbyDecade,19731998
Legendforchart:
A19731979
B19801989
C19901998
D19731998
ABCD
N
7891,4272,0404,256
AllCash
38.3%45.3%27.4%35.4%
AllStock
37.0%32.9%57.8%45.6%
AnyStock
45.1%45.6%70.9%57.6%
HostileBidatAnyPoint
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8.4%14.3%4.0%8.3%
HostileBidSuccessful
4.1%7.1%2.6%4.4%
Bidders/Deal
1.11.21.01.1
Bids/Deal
1.61.61.21.4
OwnIndustry
29.9%40.1%47.8%42.1%
Premium(Median)
47.2%37.7%34.5%37.9%
AcquirerLeverage>TargetLeverage
68.3%61.6%61.8%62.9%
AcquirerQ>TargetQ
68.4%61.3%68.3%66.0%
RelativeSize(Median)
10.0%13.3%11.2%11.7%
FractionofAcquirerAnnouncementReturns<5%
14.9%17.0%19.4%17.5%
FractionofAcquirerAnnouncementReturns>5%
9.6%11.3%10.7%11.1%

Table2:TopFiveIndustriesBasedonAverageAnnualMergerActivity
1970s1980s1990s
MetalMiningOil&GasMetalMining
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RealEstateTextileMedia&Telecom
Oil&GasMisc.manufacturingBanking
ApparelNonDepositoryCreditRealEstate
MachineryFoodHotels

Table3:AnnouncementPeriodAbnormalReturnsbyDecade,19731998
Legendforchart:
A197379
B198089
C199098
D197398
ABCD
Combined
[1,+1]1.5%2.6%1.4%[a]1.8%[a]
[20,Close]0.1%3.2%1.6%1.9%
Target
[1,+1]16.0%[a]16.0%[a]15.9%[a]16.0%[a]
[20,Close]24.8%[a]23.9%[a]23.3%[a]23.8%[a]
Acquirer
[1,+1]0.3%0.4%1.0%0.7%
[20,Close]4.5%3.1%3.9%3.8%
No.Obs.5981,2261,8643,688
Note:Statisticalsignificanceatthe5percentlevelis
denotedby[a].

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Table4:AnnouncementPeriodAbnormalReturnsforSubSamples,19731998
StockNoStockLargeTargets
Combined
[1,+1]0.6%3.6%[a]3.0%[a]
[20,Close]0.6%5.3%6.3%
Target
[1,+1]13.0%[a]20.1%[a]13.5%[a]
[20,Close]20.8%[a]27.8%[a]21.6%[a]
Acquirer
[1,+1]1.5%[a]0.4%1.5%
[20,Close]6.3%0.2%3.2%
No.Obs.2,1941,494511
Note:Statisticalsignificanceatthe5percentlevel
isdenotedby[a].

Table 5: ThreeYear PostMerger Abnormal Returns for Acquiring Firms,

1961to1993
PortfolioCompositionEqualWeightValueWeight
FullSample5.0%[a]1.4%
FinancedwithStock9.0%[a]4.3%
FinancedwithoutStock1.4%3.6%
GrowthFirms6.5%7.2%
ValueFirms2.9%1.1%
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Source:MitchellandStafford(2000).
Note:Statisticalsignificanceatthe5percentlevelis
denotedby[a].

Table6:PreandPostMergerAbnormalOperatingPerformance(AOP)

t1t+1t+2

2.92%[a]3.27%[a]3.15%[a]
[2,012][2,101][1,796]
AOP(t+1)=a+bAOP(t1)
AbR2
1.07%[a]0.804%[a]0.551[a]
Note:Statisticalsignificanceatthe5percentlevelis
denotedby[a].
GRAPH:Figure1(AggregateMergerActivity)
GRAPH: Figure 2 (Annual Value of Mergers in Deregulated Industries as a
PercentofTotalMergerValue)

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~~~~~~~~
By Gregor Andrade, Assistant Professor of Business Administration, at
Harvard Business School, Harvard University, Boston, Massachusetts.; Mark
Mitchell, Associate Professor of Business Administration, at Harvard
Business School, Harvard University, Boston, Massachusetts. and Erik
Stafford, Assistant Professor of Business Administration, at Harvard
BusinessSchool,HarvardUniversity,Boston,Massachusetts.

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