Potential targets: An analysis of stock price reactions to acquisition program announcements

Abstract

Stockholders of potential targets experience a statistically significant wealth gain of 0.59% over the 3-day window surrounding the acquisition program announcement. Potential targets are defined as those firms that subsequently receive bids. Using alternative definitions, such as a portfolio of all firms in the industry of the target or firms within the target industry with a higher probability of receiving a bid as predicted by a maximum likelihood logit model, yield qualitatively similar results. These findings suggest that events, such as program announcements, release significant merger related information well before a target is formally approached with implications for wealth effects at subsequent bids. As with normal targets, the likelihood of receiving a bid for targets that are part of a broad-based program of acquisitions increases in the level of agency problems, managerial inefficiency and in the proportion of tangible assets in the target.

Appendix

1.1 Explanations for acquisition related gains

Agency cost

Conflict of interest between agents and principals, when ownership is separated from control, has been widely recognized as a drain on stockholder wealth. This divergence of interest can lead to managers taking actions which are not necessarily beneficial to stockholders (Jensen and Meckling 1976). Takeovers, as external control mechanisms could alleviate this conflict, thereby limiting major departures of managerial actions from shareholders’ wealth maximization (Jensen and Ruback 1983). Therefore, the extent of agency conflict is predicted to be positively related to the attractiveness of a potential target.

Information signaling

Alternative forms of the information hypothesis have been distinguished by Bradley et al. (1983). One such explanation associates positive target stock price reaction to revelation of new information about the target during the bidding process. Signaling vis-à-vis potential targets in acquisition programs refers to the revaluation of target shares resulting from the possibility of a takeover bid that is generated by the information contained in the announcement of the program.

Differential efficiency

In the market for corporate control view of merger activity, takeovers represent an external disciplining mechanism with a differentially more efficient management wresting control of corporate assets that are inefficiently managed by the incumbent management (see Jensen and Ruback 1983). A fundamental premise of this view is the existence of a high positive correlation between managerial efficiency and the company's stock returns. For example, an inefficiently managed company will result in its shares being undervalued relative to their potential value and this could encourage a takeover. The announcement of the program will therefore drive up the share price of probable targets with a greater degree of managerial inefficiency in anticipation of a takeover.

Market power

When the value of the firm resulting from the merger is larger than the sum of the component parts synergy is created. Berkovitch and Narayan (1993) empirically show that synergy is the biggest motivating factor behind most mergers by documenting a positive correlation between target gains and total gains.⁴ Schipper and Thompson (1983) report negative stock price reactions to announcements of regulations that constrain merger activity. Bradley (1980) provides evidence consistent with synergistic gains to acquirers despite large premiums paid to the target share holders. Possible sources of synergy from mergers include, among others, the ability to limit competition, acquisition of complementary resources and economies of scale. Acquisition of a target can have a significant impact on the level of industry concentration with an increase in concentration being beneficial to both the target and the acquirer.