Our study investigates the Morellec and Zhdanov (2008) prediction that firms strategically underleverage to win future takeover contests. Since firms undergo arduous and long planning processes well in advance of publicly announcing an acquisition bid, they also pre-plan their financial structure. Recent survey evidence by Aktas et al. (2021) suggests that almost half of all firms prepare their acquisition strategies from five-year plans followed by initial screenings of potential acquisition targets. After identifying potential targets, firms initiate lengthy negotiations, which on average take seven months (Aktas et al., 2021). The length of the planning and negotiation process offers an opportunity for firms to align their financing and investment strategies to increase their chance of winning a possible bidding contest.
The rationale behind underleveraging can be found in Moralec and Zhdanov (2008). They suggest an endogenous role of capital structure, where the acquirer and potential competing bidders adjust their capital structures conditional upon an acquisition opportunity. The MZ model assumes that firms, in line with Kraus and Litzenberger (1973), optimize leverage by trading off bankruptcy costs against tax benefits. Therefore, successful bidding requires a costly commitment to underleverage. Acquirers recoup the costs of underleverage from synergy benefits and realign their capital structure gradually after the acquisition. Bidding competitors lose the bidding contest but receive, in equilibrium, higher tax benefits from operating with closer to optimal leverage ratios. Building on the predictions of MZ, we explicitly test whether acquiring firms actively reduce leverage prior to conducting acquisitions.
Our empirical findings lend support to the MZ theory: firms reduce leverage in response to future acquisition opportunities. As shown in Figure 1, overleveraged firms reduce their leverage to maximize their chances to win the takeover contest. We show that firms actively reduce leverage through equity issuance and/or debt retirement prior to conducting acquisitions. In further support of the MZ arguments, we find that larger deals are subject to greater reductions in leverage. To concur with the theoretical structure of the MZ commitment hypothesis, we further test the predictions in a setting involving rival bidders where the magnitude of Change in Leverage Deviation effectively predicts the winner.
Figure 1: Acquiring firms leverage deviation
The main hypothesis argues for a joint determination of capital structure and future acquisition activity. To identify that ex ante capital structure adjustments are motivated by future acquisition opportunities, we study the main determinants of adjusting capital structure based on the MZ framework: competition and expected synergies.
First, the need for de-leveraging depends on the potential competition for the target since lower competition requires less adjustments to capital structure to place the winning bid. It is empirically challenging to study competed deals as only very few deals are completed ex post competed (367 bidder observations). Therefore, we also focus on latent competition to capture the competition element in a takeover bid. We use toeholds as a firm-specific measure of latent competition and argue that deals involving toeholds are less likely to be subject to competition.
Second, firms’ willingness to deviate from optimal capital structure is positively related to the expected synergies. Because negative deviation from optimal capital structure is costly due to the reduced tax advantages, a larger leverage reduction needs to be compensated by higher synergies. We predict that bidding for large expected high synergy targets motivates larger leverage deviation. To empirically identify expected synergies, we decompose them into two components: the probability of receiving the synergies and the market-anticipated synergies. To capture the probability of receiving the synergies, we rely on hostile bids that are less likely to be accepted. To study the level of synergies we rely on the stock market-anticipated synergies. We predict that higher anticipated synergies motivate greater leverage deviation. Our results show that more competition and higher expected synergies lead to greater deleveraging.
In sum, we find that firms reduce leverage in anticipation of future takeover opportunities, highlighting the joint capital structure and acquisition decision. Our results further show that deleveraging is done not just to increase financial flexibility, but also to deter competition for the target firm.
Magnus Blomkvist is Associate Professor of Finance at Audencia Business School in Nantes, France
Karl Felixson is Lecturer of Finance at Hanken School of Economics in Helsinki Finland
Anders Löflund is Professor of Finance at Hanken School of Economics in Helsinki, Finland
Hitesh Vyas is Lecturer at Audencia Business School in Nantes, France
This post is adapted from their paper, “Strategic Underleveraging and Acquisitions” available on SSRN.