JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS Volume XV, No.

3, September 1980

MERGER AND STOCKHOLDEK RISK

Terence C. Langetieg, Robert A. Haugen, and Dean W. Michern*

I.

Introduction

In a world characterized by perfect and complete capital markets, the success (or failure) of a merger is judged by the merger's impact on stockholder wealth. With completeness, the merger's impact on the probability distribution The perfect market assumption

generating stockholder returns is unimportant.

guarantees that the stockholder not satisfied with the consolidated firm's return distribution can frictionlessly sell his shares and reorder his portfolio; hence his only concern is the merger's impact on wealth. However, if we

acknowledge the existence of commissions, taxes, and other frictions, or if markets are not complete, the merger's impact on the stockholder return distribution becomes relevant. large N.Y.S.E. firms. In this study we will analyze 149 mergers involving

We will examine four different hypotheses related to the We

impact of merger on attributes of the stockholder return distribution.

focus our analysis on risk-related attributes including beta, total variance, residual variance, and several other risk-related attributes. In a companion

paper, merger's impact on wealth is calculated for the same sample but will not be reported here. The literature provides four major hypotheses concerning merger and risk, we will refer to the four hypotheses as: (1) the "portfolio effect"; (2) the

"P/E game"; (3) the "risk-reducing effect"; and (4) the "leverage effect." The "portfolio effect" is simply an application of portfolio theory. The merger

might be regarded as nothing more than the combination of the shares of two firms into a portfolio. Assuming that the merger produces nothing that an in-

vestor could not achieve on his own, the consolidated or merger firm should exhibit the same risk attributes as a market-value weighted portfolio of the acquiring and acguired firms' stock. The "market-value weights" are determined by the value of the totaJ outstanding common stock of the merging firms at the

'university of Southern California, University of Wisconsin-Madison, and University of Wisconsin-Madison, respectively. e Langetieg [15]. "Se

689

time of the merger.

Diversification, if any, must be consistent with that imThe major support for this hypothesis comes from

plied by this portfolio.

Haugen and Langetieg [13] and Firth [8]. Although both studies indicate that some merged firms exhibit a significant change in risk from market-value weighted portfolio of the acquired and acquiring firms' stock prior to merger, the number of instances in which there was such a change is not significantly different from the number associated with a control group of firms that did not merge. Thus, the observed changes are attributed, not to merger, but to the general instability associated with the risk variable. However, Mandelker [18, 19],

who examines merger-associated changes in systematic risk via a moving average beta, rejects the "portfolio effect" hypothesis and concludes that the direction of change in risk is unpredictable. However, since Mandelker does not em-

ploy a control group in his analysis, it is difficult to assess the extent to which one may attribute these results to general instability in the risk varieible or to the impact of the merger. The second hypothesis, the "P/E game," is explained by Steiner [26] as the market's unwitting use of the acquiring firm's pre-merger P/E to value the consolidated firm's earnings. Of course, this results in instant gains if the acquiring firm's P/E is higher than the acquired firm's, thereby providing a reason for merger through the "P/E game." To the best of our knowledge, no one has seriously advanced this hypothesis. However, the hypothesis would be sup-

ported if we found that the consolidated firm takes on the risk attributes (and other attributes relevant to determining the P/E) of the acquiring firm. The "portfolio effect" and the "P/E game" are generally competing hypotheses, but are identical for beta if the betas of the acquiring and acquired firms are equal, or if the acquiring firm is large relative to the acquired firm. The

hypotheses are also identical for the variance of returns if the variances of the acquired and acquiring firms are equal and the returns of the acquiring and acquired firms are perfectly correlated. Hence, it may not always be possible The empirical work

to empirically differentiate between these two hypotheses.

of Lev and Mandelker [16] shows that the beta of the consolidated firm is, on average, insignificantly different than that of the acquired firm, a result consistent with the "P/E game." A third hypothesis comes from Lewellen [17], Alberts [1], Steiner [26], and others who propose that some mergers are motivated due to "risk-reducing effects." If true, we would expect to find the consolidated firm with a risk .

level less than that of the acquiring firm. While the "risk-reducing effect"

competes directly with the "P/E game," the "risk-reducing effect" is not necessarily inconsistent with the "portfolio effect," since the "risk-reducing effect"

690

may be entirely due to the "portfolio effect."

Lev and Mandelker's study [16] Smith and

(see above) is inconsistent with the risk-reducing hypothesis.

Schreiner [25) find that the level of diversification in conglomerates is inferior to that of mutual funds. This suggests that merger's "risk-reducing effect," as caused from portfolio diversification, is less than would be anticipated by the "portfolio effect." A foiirth hypothesis concerns the change in risk caused by a merger-related increase in leverage. Following Hamada [12] we hypothesize that mergers inNote that the

volving a higher use of leverage induce an increase in risk.

"leverage effect" is jointly present with either the "portfolio effect," the "P/E game," or the "risk-reducing effect." If the "portfolio effect" (or "P/E

game") is jointly present with the "leverage effect," we would expect the risk level of the consolidate firm to be higher than that of the market-value weighted portfolio (or acquiring firm). If the merger has some "risk-reducing effects,"

but the merger also involves an increase in leverage, the net impact is of indeterminant sign unless we also have a theory for predicting the exact magnitude of the "leverage effect" or the "risk-reducing effect." While there are

at least two ways to model the change in risk due to leverage, the analysis requires data that were not available at the time of the study. The possi-

bility of one joint hypothesis with an indeterminant sign makes the testing of any joint hypothesis impossible. Therefore, we restrict our attention to a

subsample of mergers involving exchange of only common stock and presumably no "leverage effect." However, Section VI will provide limited results for mergers involving the "leverage effect." we summarize hypotheses concerning the "portfolio effect," the "P/E game," the "risk-reducing effect" and the "leverage effect" in Table 1 for beta. Hypotheses concerning industry risk (defined in Section III) are similar, and

to the beta of an unlevered firm,

by the ratio of the value

does not affect total firm crease equity risk, but that less risky debt. ^ ' accommodate a change in

j tie relatively
ustment procedures to data involving the market debt and preferred stock.

assets to make the proper adjustment to hypotheses.

691

TABLE 1 HYPOTHESES FOR BETA (b)

Portfolio Effect

P/E Game

RiskReducing Effect

Leverage Effect

Portfolio Effect

b = b c p

Consistent only if P/E CSame

W^

Wj^

= b^

RiskReducing Effect

Consistent only if b = b = and P

Inconsistent

^c ^^^2

Leverage Effect

b c

> b P

b c

> b. 2

Testable only as Indeterminant a Joint change in ris>L Hypothesis

c = consolidated firm, p = total market-value weighted portfolio of (pre-merger) acquiring and acquired firms, 1 = acquired firm, and 2 = acquiring firm. . -

692

hypotheses concerning variances and level of diversification are similar with the exception of an additional requirement for the consistency of the "portfolio effect" and "P/E game" hypotheses, (i.e., perfect correlation in the returns of the acquired and acquiring firms is also required). Finally, we put forth the alternative hypothesis which is defined as the case where change in risk is not explained by any of the preceding hypotheses. Mandelker [18, 19] reports that the direction of the change in risk is unpredictable, a result suggesting this alternative hypothesis. The results of this study also support this alternative hypothesis but, unlike Mandelker, we find the merger accompanied by an (unhypothesized) increase in risk.

II.

The Sample Profile

The total sample consists of 149 mergers taken from the period 1929 through 1969, with the majority, 61.8 percent, of the sample from the 1960s, 25.8 percent from the 1950s, and 12.4 percent before 1950. We focus our attention on a subsample of 82 mergers involving an all common exchange to avoid complications that arise if a merger is accompanied by a change in leverage (see Section I ) . The total sample encompasses all mergers on the Center for Research in Security Prices (CRSP) data file which meet the following screening criteria: 1. The firms must have at least 36 months of readable data in the period surrounding the merger. 2. For each merger included in the sample, both firms must not have merged more than once in the three-year period before and after the merger date. The use of the CRSP tapes and the screening criteria unavoidably limits the sample to successful mergers between large, infrequently-merging firms. The first screening requirement is necessary to insure a minimum amount of data for analysis, but it also screens out some unsuccessful mergers (i.e., delisted firms). The second screen eliminates frequently-merging firms in order to The use of the CRSP data file limits

focus on the impact of a single merger.

the sample to mergers between N.Y.S.E. firms, which are typically very large companies. We caution the reader that the results of this study may not be ;^ ^

generalizable to the class of all mergers. Since a merger is a relatively unique event in the life of a firm, it may be useful to examine subaggregates defined with respect to sample characteristics Focusing on the total sample -(149 mergers), the heaviest merger activity

occurred in the industrial-raw-material sector (45 acquiring firms, 42 acquired firms), followed closely by the industrial-products sector (35, 36) with the 693

consumer sector

(21, 26) coming in a distant third.

The petroleum (18, 14),

transportation (15, 15), and wholesale sectors (7, 10) have a modest representation, and there are only a few mergers from the financial (6, 4) and service sectors (2, 2 ) . Seventy-nine mergers involve two industries, while 70 involve a single industry. Looking at the type of consolidation as defined by the FTC

[7], we find 22 percent horizontal mergers, 12 percent vertical mergers, 12 percent market-extension mergers, 38 percent product-extension mergers, and 16 percent pure-conglomerate mergers. In this sample, 72 percent of the mergers

occurred in a rising or peak stock market, and nearly 80 percent of the mergers occurred during periods that could be considered as having a higher than normal level of merger activity in the economy. The average acquired firm was 39 per-

cent the size of the acquiring firm with respect to t:otal market value of outstanding common stock, and 26 percent the size of the acquiring firm with respect to product-market share. Nearly 55 percent of the mergers involved a

nontaxable exchange of only common stock, while 20 percent of the mergers were taxable to some extent.

III.

Definition of Risk Attributes

Assume, in accord with Jensen's two-factor, "instantaneous horizon," return generating model [11], that individual security and industry average returns are generated by the following stochastic processes:

where a = a measure of security j's average-excess return over T time periods (also known as the Jensen performance index [11]),

a^ = a measure of industry I's average-excess return over T time periods,

The empirical evidence of Fama and MacBeth [5], Black-Jensen and Scholes [2], Friend and Blume [10], and Pettet and Westerfield [22] indicates a returngenerating process of the following form: , r. - r = b.(r ^ - r ^) + e. ^ jrt 2,t 3 m,t z,t 3,t

where r^ ^ is the rate of return on a minimum variance zero-beta portfolio. All of the analysis of this study has been replicated using the estimates of " 2 t '^^^^^^^ ^y Fama-MacBeth. The results for the zero-beta model are uniformly ^ consistent with the results for the risk-free rate model (see equations (1) and (2)) and will not be presented here.
.:
-

.;

-; .

6 9 4

= the beta of industry I,

pJrir

' portfolio of stocks representing industry

and

""''^"""'' " ^ " " associated with a risk-free asset in period t.

''m,t ^^^ continuous return for the market portfolio in period t. By assumption; ,t ^^^ identically and independently distributed (iid) with 2 2 zero means and variances a. and o respectively. COV(e., (r^ ~ ^p^^ = 0Finally, we also assume that the residual e^ ^ can be expressed as a linear function of the residual e
1, U

plus an independent'error.

where u J t

is iid, CX)V(u,,e_) = 0, and E(u.) = 0. j I j The

J , ;

Here the variable e^^^ represents the influence of all nonmarket factors. term d e^. ^ represents the influence of security j's industry, and u.

repre-

* U

sents the influence of firm-unique events and other factors not already accounted for by the market and the industry. Substituting (3) into (1) yields:

;?f

^'^: :

"^j.t - ^F,t = ^j * ^

^^m,t - ^F,t' - <^jI,t " "j,t ^

Compared to the simpler market model (i.e., r. = a. - b r ^ + e'. ) , model j,t j 3m,t 3,t (4) has two advantages. First, the inclusion of the risk-free rate avoids the By construction,

"missing variable bias" that results when COV(r , r ) j 0. f

the industry residual, e , is uncorrelated with the market-risk premium, (r . - r ) . Therefore, the inclusion of the industry factor does not affect m,t F,t the estimate of beta. In cases where the industry provides sufficient additional explanatory power, confidence intervals for regression coefficients are

See Itoll [24] or Miller and Scholes [20] for a discussion of this bias. The industry factor provided significant additional explantory power at the 5 percent level in over 84 percent of the acquired firms, 88 percent of the acquiring firms, and 51 percent of the consolidated firms. 695

strengthened.

Note also that the industry factor manifests itself only in the

ex post generating process, not in the determination of the expected rate of return, (i.e., expected rate of return is assumed to be determned according to the capital asset pricing model E(rJ = ECr^) + B^[E(r^)-E(rp)]). In this study the market return, r^, is taken to be Fisher's equallyweighted Arithmetic Link Index [9]. This index is broadly based and has been used in many other merger studies [13, 18, 19], so its use in this study should prove valuable for comparative purposes. The three-month treasury bill rate

[6] is used as proxy for the risk-free rate. An equally-weighted industrial index is constructed for each merging firm. Obviously, the merging firms are not used in the index. To create greater homo-

geneity among the firms included in the index, an initial, equally-weighted portfolio is constructed of all firms in the merging firm's two-digit industrial classification. The correlation of the residuals for this portfolio and the

residuals for each constituent firm is calculated, and the firms are rank ordered. The 10 percent of the firms having the lowest correlation coefficients

are eliminated, and the index is computed on the basis of the remaining firms. The risk measures relating to the market-value weighted portfolio, the acquired firm, and the acquiring firm are estimated usinq monthly returns over the period from 72 months before to 12 months before the merger date. The risk measures relating to the consolidated firm are estimated in the period from 12 months after to 72 months after the merger date. The intervening period around

the merger date is eliminated on the basis of the possible presence of temporary nonstationarity in the coefficients induced by preliminary negotiations, by the announcement of, or by the preliminary assessment of the merger's results. Nonstationarity may still be present in the time intervals used to calculate risk measures. The use of five years of data in calculating risk measures represents

a trade-off between using a sufficient amount of data to construct reasonably tight confidence intervals and the use of less data corresponding to shorter

The residual, e, is computed on the basis of a regression of the following form:

r.

= a. + b . r

^ + e. . .

,. ' -.

j.t

D m,t

],t

:^ ; '

An alternative index is also employed, and all the results have been replicated using this index. In this alternative index the weights are related to the magnitude of the correlation coefficients for the residuals. The results using this index are basically similar to the results reported in this paper. We also acknowledge that it would be preferable to use three- or fourdigit S.I.C. classifications to form the industry index, but the C.R.S.P. tapes are simply not large enough to form such indices for most of the merging firms in our sample. .; , ,; . .. , "';.. / y : ' . :. '! z ^ ! ^ ?- ^ - ' - ' . l ^ ' : > ; . ' ; ; ' , ; , : , > ' - :

.'';:\->.'"

.:'

'-'

6 9 6

time intervals and greater stationarity.

The impact of nonstationarity of beta

is analyzed in some depth by Mandelker [18, 19]. in addition to market risk and industry risk we analyze several additional attributes of the return distribution:

(5)

VAB(r) = variance of total returns, VAR(R) = variance of the risk premium (R=r-r ) , VAR(u) = residual variance, net of market and industry influence, VAR(e) = diversifiable variance (i.e., residual variance net of only market influence, VAR(e) = d2 VAR(e ) + VAR(u), COR(u) = [1 i ] = the coefficient of multiple correlation VPiR{r-r^} which measures the level of residual variance relative to risk-premium variance, i ] = the coefficient of multiple correlation VhR{r-r^) which measures the level of diversifiable variance relative to risk-premium variance, and VAR(e) VAR(u)

COR(e) = [ 1

MAD(R) = Z I R^ - R I = mean absolute deviation of the risk premium.

IV.

Statistical Tests and the Control Group

Three different tests are used to examine the merger's impact on risk. The construction of the tests is described in the Appendix. We will explicitly test Since the "P/E game"

only the "portfolio effect" and the "P/E game" hypotheses.

and "risk-reducing effect" are mutually exclusive, we can infer that a "riskreducing effect" is present only if the "P/E game" is rejected, and the rejection is accompanied by a risk reduction. The key test statistic is the "dif-

ference," which is defined as the hypothesized risk level minus the consolidated firm's risk level. 1. There is a test for the magnitude of the "difference." sis holds, the "difference" should be equal to zero. are "standardized" and aggregated. If a hypothe-

The "differences"

If a hypothesis holds, the aggre-

gate of the "standardized differences" should also have a mean equal to zero. 2. There is a test for the percent of positive "differences" or risk changes. Noting that the "difference" is nearly symmetrically distri-

buted, we would expect an approximately equal number of positive and ' 3. negative "differences" if a hypothesis holds. There is a test for the percent of mergers having a "difference" that is significantly different than zero at the 5 percent level. If a

hypothesis holds, we would expect the percent of the sample with 697

significant changes to be less than or equal to 5 percent.

We also

exainine the number of positive and negative significant "differences" by a similar procedure. Each test statistic has unique advantages and disadvantages. It is quite

possible that one test could show that the merger has a significant impact while the other tests do not. Ideally we would find all tests indicating a 8 significant impact, or all tests indicating an insignificant impact. A control group is employed to serve as a check for sources of systematic bias in merger results. The combination of potential bias introduced from misspecification of the return generating model, errors in measuring the independent variables, violation of the assumption of normality, and nonstationarity in regression coefficients could lead to a false signal of statistical significance in the tests for changes in stockholder risk. If the bias is introduced

in a systematic manner, then the bias may also be reflected in a significance test performed for a nonmerging control group. Hence, the control group serves

as a check for systematic bias in the statistical tests. In cases where both the control group and the merging group show significant rejection of a hypothesis, we must acknowledge the possibility of a systematic bias. One method for "netting out" systematic bias is to perform a

paired-comparison test. Each merger statistic is compared with the corresponding control statistic. The difference between the two statistics represents If a hypothesis holds, the aggregate of the

the merger's net impact on risk.

paired differences should have an expected value equal to zero. One control firm is selected for each of the merging firms (both acquired and acquiring). The residuals (as given in footnote 6) of the merging firm The

are compared to the residuals of each firm in its two-digit SIC industry.

firm having the highest residual correlation with the merging firm is selected as the control.

^It should be noted that hypotheses involving regression coefficients can be tested simultaneously. For example, the "portfolio effect" for beta and for the industry coefficients can be combined into a single joint hypothesis : which can be assessed by a constrained, least-squares procedure, resulting in. an F-test. Simultaneous tests were made, but the results are not reported ; ; in this study. However, the results are highly consistent with the results from individual hypotheses, see 114].

698

V.

Results: The Effect of Merger on Stockholder Risk (All Common Exchange) ~ ~ ^^ Table 2 pro-

The results of the tests are presented in Tables 2 and 3.

vides the results for tests relating to regression coefficients, and Table 3 presents the results for the remaining risk variables. Turning first to the

beta coefficient. Table 2 shows the results of three statistical tests made for the merging firms, the control group, and the paired comparison. The results

Clearly indicate that the consolidated firms' beta is on average slightly greater than one would expect for the "portfolio effect," the "P/E game," or "the risk-reducing effect." Unlike the merging firms, the control firms exhibit a Moreover, the paired-comparison test indicates

Significant reduction in beta.

there is a statistically significant difference between the change in risk in the control group and the change in risk in the merger group. The ability of

the merging finns to maintain their risk levels in the presence of generally falling risk levels for closely associated firms might be taken as evidence supporting the presence of a merger-induced risk change in this sample. one source of systematic bias that is correctable is the tendency of betas to "regress toward the mean." Blume [3] has reported that nonstationarity in

beta is systematic because, in general, firms exhibit a propensity to regress toward their (cross-sectional) mean value of one. This tendency is correctable,

to the extent that it is uniform for all securities, by applying Blume's correction formula to the post-merger beta. The tests for beta were replicated after The results of these

allowing for the regression toward the mean phenemenon.

tests reinforce the conclusion that the consolidated firm experienced an increase in beta not anticipated for by any of the three hypotheses. Turning now to other aspects of the return-generating process. Table 2 shows that both the merger group and the control group are associated with changes in the industry risk that are inconsistent with both the "portfolio effect," the "P/E game," and the "risk-reducing effect." However, the paired-

comparison tests shows that the difference in behavior of the two groups is not strongly significant. This leaves open the possibility that the change in in-

dustry risk is due to the presence of a systematic influence, such as general nonstationarity, rather than the impact of the merger. Table 3 provides the result for the remaining risk measures: total vari-

ance, VAR(r); risk-premium variance, VAR(r - r^) , diversifiable variance, VAR(e); residual variance, VAR(u) , relative diversifiable variance, COR(e) ; relative residual variance, COR(u); and the mean absolute deviation, MAD(R). The re-

sults indicate that every risk measure increased, which is again inconsistent '^ith all three hypotheses. While the control group also exhibits similar behavior for all risk measures, except COR(u) and COR(e), the "net" change in risk 699

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as measured by the paired-comparison test is still positive and significant. However, both the "portfolio effect" and the "P/E game" are acceptable in the paired-comparison test for COR{u) and COR(e). While it appears that the data are inconsistent with all three hypotheses, it is interesting to compare the relative explanatory power of the three hypotheses. Examination of Tables 2 and 3 shows that the "portfolio effect" and

the "P/E game" are rejected for most risk measures, and the level of rejection is highly similar. For some risk measures the "portfolio effect" is acceptable

in the paired-comparison tests, but we find that the "P/E game" is also acceptable in those cases. In cases where both of these hypotheses are rejected, we

generally find an increase in risk, which implies that the "risk-reducing effect" is even more strongly rejected. An explanation for the similar results

for the "portfolio effect" and the "P/E game" is provided by the observation that the acquired firm and acquiring firm have similar risk levels, particularly for beta. This implies that the levels of risk in the market-weighted port-

folio and the acquiring firm are approximately equal; hence it is extremely difficult to empirically discern the difference between the "portfolio effect" 9 and the "P/E game" in this sample. To summarize, on the basis of the results thus far, we have been able to reject all three hypotheses as adequate explanations for the behavior of the risk variables including beta, VAR(r), VAR(r-r ) , VAR(e), VAR(u), and MAD(R). The "portfolio effect" and the "P/E game" are rejected less strongly (and are even acceptable in the paired-comparison tests) for changes in the industry coefficients, COR(u) and COR(e). Thus, at this point, the evidence seems to

lean in favor of the alternative hypothesis, the rejection of all three hypotheses. In the next section we shift to a consideration of subaggregates and examine the risk changes for mergers of difference types.

9 We would expect that the "portfolio effect" hypothesis (that b + w b ) , will be equivalent to the "P/E game" hypothesis (that b
^ z c

= w b
z

= b _ ) , when

w^ is large with respect to w

or when b

= b-,- Limiting the sample to 41 :-);;...

mergers where w^ < .3 andlb - b2l> .25, we find the "portfolio effect" rejected for 24.4 percent of the mergers (all increases) while the "P/E game" is rejected for only 7.3 percent of the sample. Before concluding that the "P/E game" better fits the data than the "portfolio effect," it should be noted that both hypotheses are equally rejectable when looking at other tests.

704

^^

The Nature of Merger and the Change in Risk

In this section we try to isolate groups of mergers that are distinctive m terins of their tendency to experience a change in risk. We then subaggre-

gate the total sample (149 mergers) to make a rigorous measurement of the change in risk for each subaggregate. Because of the significance of beta to

the theory of finance, and because the results of Section V indicate that significant deviations from the "portfolio effect" hypothesis occur with respect to beta, we focus our attention on the "portfolio effect" for beta.^ A regression procedure is used to screen the total sample for firm and merger characteristics that may have a significant bearing on the degree of risk Change experienced. The dependent variable is the "difference" which is

defined as the level of risk in the market value weighted portfolio minus the level of risk in the consolidated firm, (b^ - t.^). The independent variables

are descriptive of the nature of the merger and are either continuous or discrete, depending on their nature.^^ First, we employed ordinary least squares,

regressing the "difference" on each of the different independent variables. Then, a series of step-wise multiple regressions are employed to study the interactive effect of the independent variables.

10 ^ ^ " ^ f^""" the "P/E game" hypothesis with respect to beta were also ' / ^ ' deviations from the "P/E game" are similar to the deviations

L siSL?for S'^'"r''"/"' '"' explanatory power of exogenous variSleT

direction fly. ^ " , ^ypo tl.es es with respect to the significance and the direction of the relationship between the deviation and the exogenous variable. Eight sets of independent variables are used in the regressions: (1) The nature of the securities used for compensation in the consolidation (e.g., only coimnon stock used in exchange, other securities used in exchange, nontaxable exchange, taxable exchange) (2) Dummy variables relating to the type of merger (horizontal, vertical, product-extension, market-extension, and pure conglomerate) (3) Dummy variables relating to the industries of the acquired and acquiring companies. ^

(4) The performance of the stock market in the period around the merger date (5) The relative size of the acquired and acquiring companies with respect ' to total market value of common stock at the time of merger (6) The historical time period of merger, where the time periods refer to the^four ten-year periods and eight five-year periods included in this : (7) The level of (economy-wide) merger activity in the year of merger (8) The increase in the share of the market for the acquiring company's product resulting from merger (defined only for single industry mergers) . Other explanatory variables are volatility of revenues, changes Of after-tax income, changes in nately, none of these variables suggested in the literature: changes in the in operating leverage, changes in the volatility the volatility of "cash flows," etc. Unfortuwas readily available at the time of this study

705

Variables identified as having "distinctive" behavior in simple regressions and in step-wise, multiple-regression procedure included: taxable mergers; mer-

gers involving exchange of bonds; preferred stocks or assets; pure conglomerate mergers; mergers occurring in the consumer sector; and mergers occurring in the financial sector.^^' ^^ Mergers associated with other subaggregates (e.g.,

historical time of the merger, relative size of merging firms, etc.) exhibited a tendency for risk change that was not significantly different from that of the total sample. Variables identified as having a distinctive tendency for risk change in the regressions are used to subaggregate the total sample, and the more rigorous tests employed in Sections IV and V are applied to the resulting subaggregates. Results are shown in Table 4. All of the subaggregates are seen to

have a greater than average tendency toward a change in risk, which is typically an (unhypothesized) increase in risk that is of even greater magnitude than the increase in risk experienced by the "all common exchange" subaggregate. Hence, the results for subaggregates are uniformly consistent with the results reported for t h "all common exchange" subaggregate in Section V. ;e Again, we 14 conclude that the "portfolio effect" hypothesis is empirically unsupportable. Finally, we examine a new sample of mergers involving bonds, preferred stock, or cash in the exchange. leverage. Such mergers typically involve an increase in

The results suggest an even greater tendency for these types of mer-

gers to be associated with an increase in risk than was found in mergers involving an all-common exchange. Of course, this is exactly what one would expect

since increasing leverage implies an increase in the risk level [12] . The

We caution the reader against interpreting "distinctive" (i.e., distinctive in terms of the tendency to experience a change in risk) as a "statistically significant distinction." The motive for subaggregation is to extend the examination of the "portfolio effect" hypothesis for subaggregates. Our regressions are merely a "first pass" attempt to identify subaggregates with a distinctive tendency for risk change. A more rigorous treatment of subaggregates is reported below. ^\hile the "all-common exchange" subaggregate is easily justified to extract from the leverage effect, subaggregation with respect to characteristics such as industry or type of merger needs further theoretical justification. Furthermore, the subaggregation for conglomerate, consumer, and finance mergers should be treated with caution because of the small sample size for these subaggregates . Although the empirical results are not reported, the "risk-reducing" hypothesis and the "P/E game" hypothesis are also inconsistent with the data for most subaggregates.

706

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"taxable" subaggregate experienced an even greater risk increase, which is probably due to the fact that the set of taxable mergers includes many mergers where bonds, preferred stocks, or cash represent 100 percent of the exchange. Hence, taxable mergers in this sample were typically mergers having a very large "leverage effect." Since the "leverage effect" seems to be present, a rigorous

test of the "portfolio effect," "P/E game," or "risk-reducing effect" for this subaggregate requires the prediction of the magnitude of the "leverage effect" (see Section I and footnote 2 ) .

VIX.

Summary and Conclusions

This paper has reported the results of an in-depth study of the changes in risk associated with a large sample of merging firms involved with an all-common exchange. The analysis has attempted both to measure and to explain the changes The evidence provides some support for the notion that mer-

in risk attributes.

ger has an impact on stockholder risX, but it is generally not of a form that has been suggested by others in the literature. On the average, we find that

merger tends to be associated with an vinexpected increase in the levels of both systematic, total, and diversifiable risk for the consolidated firm. surprising result, as merger is rarely viewed as risK-increasing. This is a

While the

literature would lead us to believe that some mergers are motivated to reduce risk, we find more may be motivated to increase risk. However, a risk increase

is not necessarily inconsistent with stockholder wealth maximization if capital markets are reasonably perfect and complete and providing that expected profits increase in a commensurate amountTo conclude this study we ask, "Why is merger associated with risk increases?" While an increase in leverage may account for part of the risk in-

crease in some mergers, the risk increase in mergers involving an all-common exchange is not adequately explained by any of the available sample characteristics. Hence, further research is warranted with respect to the examination of

additional explanatory variables (see footnote 11). Finally, we suggest that the increasing risk level may only reflect an aggressive management in the acquiring firm. The fact that many mergers are also accompanied by an increase

in leverage supports this viewr

709

APPENDIX A. Construction of Aggregation Statistics For the "portfolio effect" and the "P/E game" hypotheses for each risk measure, three statistical tests are constructed which involve the aggregation of : (1) standardized "differences"; (2) positive "differences"; and To illustrate the three tests consider the

(3) significant "differences."

"portfolio effect" hypothesis expressed for changes in beta. Define d. as the "difference" between the hypothesized risk level and the consolidated firm's risk level. Then, d. = b . - b . for merger i, where b . and b . refer to the
1
pi Cl pi Cl

beta of the market-value weighted portfolio and the consolidated firm respectively. According to the "portfolio effect," hypothesis E(d.) = 0 for each merger i. The first test concerns aggregation of standeirdized "differences." Before

the "differences" are aggregated, they are standardized by dividing each d. by its estimated standard deviation, SD(d.).
1

Noting that d. = b . - b ., that

1 . pi Cl

b . and b . are calculated from nonoverlapping time intervals, and assuming that security returns are serially independent [4], it follows that SD(d.) = [VAR(b ^) + VAR(b ^)] (see Table 5). Next, define the aggregate average d as: 1 " d = - Ed:

where n is the sample size, and d! is equal to d./SD{d.).

Since n is rela-

tively large (82 mergers), we appeal to the central limit theorem and assume the distribution of d to be approximately normal. According to the "portfolio effect," hypothesis E(d.) = 0 for each i, and this implies that E(d) = 0 , which is the aggregate form of the "portfolio effect" hypothesis. To test E(d) = 0

we construct a (1 - 2a) percent confidence interval based on the normality of d. Assuming independence of the "difference" across mergers, d has a sample The "portfolio effect" hypothesis is accepted if and only if

variance of 1/n.

zero is included in the confidence interval. The second statistical test involves aggregation of the number of mergers having positive "differences." Assuming the "difference" is approximately sym-

metrically distributed, we would expect an equal number of positive and nega- : tive "differences." Define p as the proportion of positive "differences." ,v ,

Again assuming the "differences" are independent across mergers, p will be approximately normal, with estimated SD(p) = [ p (1-p)]*. A (l-2a) percent

confidence interval for the aggregate form of the "portfolio effect" hypothesis (i.e., E(p) = .5) is constructed, and the hypothesis is accepted if and only if .5 is included in the confidence interval. The assumption of symmetri-

cally distributed "differences" is strongly justified for the regression 710 , .., . .,..

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coefficients since they are approximately normal, but not as strongly justified for the variance risk measures and for the correlation coefficients, which m y also be slightly nonsyitimetrical. The third statistical test involves aggregation of the number of mergers having a significant "difference" from the hypothesized risk level. Significance is determined by a 95 percent confidence interval constructed for the individual "differences." The distribution of the "differences" varies according to the risk measure being examined and is as shown in Table 5. It should

be noted that the assumption of normally distributed returns is used in deriving distributions for the different risk measures. If the "portfolio effect"

hypothesis holds and we conduct a large niomber of independent tests, using a 95 percent confidence interval, then we would expect significant departures from the hypothesis in 5 percent (or less) of the tests. Assuming that the tests for significant "differences" are independent across mergers and noting the sample size is large, the distribution of s, the proportion of significant "differences," will be approximately normal, with an estimated standard deviation equal to: [ s(l-s)] . A (1-a) percent critical level for the hypothesis The "portfolio effect" hypothesis is accepted

that E(s) .05 is determined.

only if .05 is less than or equal to the critical level. The three statistical tests defined above have unique advantages and disadvantages. The "standardized-difference test" is subject to domination by a The "standarized-

few mergers having extremely large standardized "differences."

difference test" and the "percent positive test" may fail to pick up significant departures from a hypothesis if "differences" are offsetting (i.e., a significant positive difference offset by a significant negative difference of comparable magnitude). The "percent-positive test" is also dependent on the The "percent-significant

symmetry of the distribution of the "differences."

test" is dependent on the normality of security returns, which has been questioned by Fama [4) and others. will fail to In addition, the "percent-significant test"

detect "differences" that are nonzero but too small to be statisFinally, all tests are subject to the assumption of crossSince no test is

tically significant.

sectional independence among the "differences" in the sample.

ideal, we employed all three tests in analyzing the merger's impact on risk. B. The Paired-Comparison Test -

The aggregate tests described above are performed for both the merger group and the control group. In cases where the aggregate tests produce similar re-

sults in the two groups, there is a possibility that some external factor, other than the merger itself, has caused the similar result. a number of sources of potential bias, including: In general, there are

(1) nonstationary risk

measures; (2) specification errors in the generating process used in calculating regression coefficients; (3) errors in measuring independent variables in regressions; (4) violation of assumptions used in forming statistical tests; and (5) characteristics peculiar to the sample (e.g., the sample involves mergers between infrequently merging, established N.Y.S.E. firms in which the merger is not totally unsuccessful in that the consolidated firm remains listed.) The

influence of these external factors can be moderated to the extent that the influence is exerted systematically on the merging and control firms. One way to moderate external, systematic influence is to use the pairedcomparison test. Define the "paired difference" D, as: D, = d , - d , where

mi

ci

d , and d , denote the "difference" for merger i and its control merger respectively. According to the "portfolio effect" hypothesis, E(d ,) = 0 and ml This implies that E(D,) = 0. We consider the aggregate form of

E(d ,) = 0.

the "portfolio effect" hypothesis which implies that E{D) = 0, where 5 = Z D,/SD(D,); that is, 5 is the sample average of the standardized D, . Again assuming cross-sectional independence of the D,, D is approximately normally distributed with SD(D) = n , and a (l-2a) percent confidence interval

E(5) can be constructed. To conpute SD(D,) used in standardization, we note that VAR(D,) = VAR(d ,) + VAR(d ,) - 2C0V(d ,,d . ) . We assumed that the latter i mi ci mi ci covarieuice term is negligible. For regression coefficients and the residual variance, this assumption is justified since there is little reason to suspect that the residuals (net of market and industry influence) of the merging firms and control firms are correlated. In fact, the residual correlation between

merging and control firms was calculated and found to be positive but quite small in magnitude. In only a handful of cases was the correlation significant.

Hence, the assurption of a zero covariance seems justified in the case of the regression coefficients and the residual variance. However, it is acknowledged

that this assumption is violated to some extent in other risk measures. A paired-comparison test is also constructed for positive and significant "differences" in the two groups. Let P = p^^ - P^,. where p^ and p^ denote the pro-

portion of positive "differences" in the merger group and control group. Again, assuming independence of the "differences," P will be approximately normally distributed with VAR(P) = VAR(p^) + VAR(p^) = [i^P^d-P^^) + " ^c^^'^c^ ^ "^^^ aggregate form of the hypothesis implies that E(P) = 0 is then tested by determining a (l-2a) percent confidence interval for E(P). A paired-comparison test

for the proportion of significant "differences" is made by analyzing S = s^ - s^ where i and i denote the proportion of significant differences in the merger Assuming independence of the "differences, S will

group and the control group.

be approximately normal, and a (l-2a) percent confidence interval for E(S) allows one to test the hypothesis that E(S) = 0 . 715

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'"' *r;o^K,"-;.Sfwrt; S^f"^.

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717