Are bidders in mergers and acquisitions (M&A) able to exploit their overvaluation by using overpriced shares as acquisition currency? The question has been debated within the financial economics literature since Shleifer and Vishny (2003) and Rhodes-Kropf and Viswanathan (2004) put forth theories suggesting that misvaluation drives the payment method in M&A deals. These seminal papers have major implications for the efficiency of the market for corporate control as they indicate that M&A deals might fail to allocate target assets to the most suitable bidder. This topic is of first order importance as inefficiencies in the corporate takeover market might lead to reduced economic efficiency at large. This importance is underscored by the fact that the global M&A market has increased dramatically over the last decades and just set a new record with a deal volume of more than $5 trillion in 2021. Early empirical work has found support for the theoretical prediction that overvalued bidders prefer to use stock payment in acquisitions (bidder opportunism hypothesis) by showing that the bidder’s market-to-book (M/B) ratio, or its misvaluation component, are positively related to the share of stock in M&A deals.
Two recent contributions, however, challenge these findings. First, there is strong evidence that the positive association between the bidder M/B ratio and stock payment was caused by regulatory incentives. Specifically, prior to July 2001, bidders who paid fully in stock were able to record target assets according to the “pooling of interest” method. Under pooling accounting, acquirers were able to fuse the financial statements of the involved parties without revaluing target assets or recording any goodwill. Since management compensation is often tied to performance measures such as return on assets, which are negatively affected by inflated assets, managers of bidders were mechanically incentivized to conduct stock-swaps, especially when target valuations were high. Due to the positive correlation of acquirer and target valuations, pooling accounting has caused a positive correlation between the bidder M/B ratio and stock payment. The effect of bidder M/B on the payment choice vanishes after the abolishment of pooling accounting. Second, stock payment is more likely if the target knows more about the acquirer (there is less asymmetric information) and higher bidder M/B ratios do not lead to more stock payment in acquisitions, when solely exogenous variation in the M/B ratio is considered. Based on these results, Eckbo, Makaew and Thorburn (2018) conclude that bidder opportunism is not a major driver of the payment method in M&A deals. In contrast, the authors argue that their findings are consistent with a rational payment hypothesis, where the bidder is primarily concerned about the target’s ability to accurately value them.
In our recent paper, we argue that most prior evidence against (and in favor of) bidder opportunism relies on noisy measures of corporate overvaluation. While large parts of the literature rely on the M/B ratio or its decomposition to identify corporate misvaluation, this approach remains controversial. A main issue of the M/B ratio is that it also captures a firm’s future growth options and its risk profile, indicating a potential measurement error of misvaluation using the M/B ratio. Therefore, we reexamine the prior evidence by adopting a new measure for acquirer misvaluation from the asset pricing literature: the mispricing score. The mispricing score is constructed as monthly average of the relative ranking (across all stocks listed at the NYSE, AMEX and Nasdaq with share prices larger than 5$) of eleven stock market anomalies, which have all been shown to predict subsequent abnormal returns. The measure has been examined extensively in the (behavioral) asset pricing literature, yielding strong evidence that the measure well identifies relative over- and undervaluation of stocks.
Empirical Evidence for Bidder Opportunism
As a first step, our empirical analysis shows that the mispricing score successfully predicts stock payment in M&A deals. A one standard deviation increase in the mispricing score raises the percentage of stock in the payment mix by 4.3 percentage points, which is economically large given a sample mean of 24.47% paid in stock. Our results underscore that overvaluation is a major determinant of the payment choice. Similarly, a firm’s mispricing score strongly and significantly predicts seasoned equity offerings (SEOs) and share repurchases. These results imply that misvaluation directly affects different types of corporate actions. Next, we show that acquirer overvaluation continues to predict full stock payment after the abolishment of pooling accounting in 2001 and also for acquirers voluntarily opting against pooling accounting before 2001. Therefore, the relation between bidder overvaluation and stock payment is not driven solely by pooling accounting.
We go on to document that acquirer mispricing predicts the percentage of stock payment even after controlling for measures of asymmetric information between the target and the acquirer. Based on these results, we argue that bidder opportunism is at least as important as the rational payment hypothesis for M&A payment choice. Additionally, we use an instrumental variable approach to make sure we do not just identify a correlation between overvaluation and stock payment, but a causal relationship. We use price pressure from mutual fund outflows as an exogenous instrument for the bidder’s mispricing score. Again, we find an economically large and statistically significant positive effect of acquirer mispricing on the share of stock payment. Our result implies that the relationship between overvaluation and stock payment is most likely causal, confirming that bidder opportunism indeed affects the M&A payment choice. We argue that the insignificant results found in the recent literature can be attributed to the limitations of the M/B ratio and its decomposition in measuring bidder overvaluation. Consistent with the bidder opportunism hypothesis, we also find that stock acquirers substantially underperform cash acquirers in the long run after the acquisition, indicating that the overvaluation signaled by stock payment is subsequently reversed.
Further analyses show that bidder announcement returns are lower for deals with high stock payment and high familiarity (low asymmetric information) between the target and the acquirer. We interpret this finding as evidence that markets on average do not appreciate targets to accept stock payment when they should know more about the acquirer’s true value, which casts additional doubt on the claim that the rational payment hypothesis has more explanatory power than the bidder opportunism hypothesis. We argue that the positive effect of the information asymmetry proxies on stock payments in combination with the negative effect on bidder announcement returns of stock mergers might rather illustrate an irrational target management and shareholder preference for stocks of familiar acquirers. The finding is consistent with the literature on investor behavior, which argues that investors’ preference for local stocks and firms operating in familiar industries is indicative of a familiarity bias rather than superior information. Our results imply that a similar familiarity bias might allow bidders to dupe target managers and shareholders into accepting overvalued stock.
Finally, we show that bidder CEOs with prior financial expertise are more likely to use stock payment when their company is overvalued. In our view, this result is additional evidence in favor of the bidder opportunism hypothesis as the bidder CEO’s financial expertise should help her to identify situations when the bidder can exploit its overvaluation.
In our paper, we address an important question in the M&A literature: Do overvalued bidders opportunistically use their own stock as payment method? Introducing a new mispricing measure from the asset pricing literature, we find strong and consistent evidence for bidder opportunism. Considering a multitude of specifications and tests, we show that the economic effect of acquirer mispricing on the M&A payment choice is economically large and likely causal. We also document that financial expert CEOs are particularly responsive to their stock’s mispricing.
Our findings have several important implications. First, we contribute to the ongoing debate on the question whether bidders opportunistically exploit their overvaluation. By adopting a new mispricing measure, we are able to provide strong evidence for inefficiencies in the market for corporate control. Specifically, our results imply that the best suited buyer will not necessarily succeed in winning the target, sometimes it might just be the most overvalued one. Second, our adoption of the mispricing score has important implications beyond bidder opportunism. As anomalies and associated mispricing are central topics of the empirical asset pricing literature, corporate finance research might profit from leaning more strongly on corresponding measures from the empirical asset pricing literature. Third, our results have an interesting implication for the literature on behavioral corporate finance. Typically, irrational investors and irrational managers are treated as two separate literature strands in behavioral corporate finance, while our findings on CEO’s financial expertise indicate that market and manager characteristics interact. In fact, financial experts are systematically better at exploiting market inefficiencies than CEOs without prior financial expertise. Thus, future research should increasingly examine the intersection of both literature strands.
Nils Lohmeier is a PhD student at the Finance Center of the University of Münster.
Christoph Schneider is a Professor of Finance at the University of Münster.
This post is adapted from their paper, “Overvalued Acquirers Still Prefer to Pay with Stock,” available on SSRN.
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.