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«INTRA-INDUSTRY EFFECTS OF TAKEOVERS: A STUDY OF THE OPERATING PERFORMANCE OF RIVAL FIRMS Rupendra Paliwal, Sacred Heart University ABSTRACT This ...»

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The International Journal of Business and Finance Research ♦ Volume 4 ♦ Number 2 ♦ 2010

INTRA-INDUSTRY EFFECTS OF TAKEOVERS: A

STUDY OF THE OPERATING PERFORMANCE OF

RIVAL FIRMS

Rupendra Paliwal, Sacred Heart University

ABSTRACT

This paper investigates whether the managers of industry rivals act to mitigate their agency exposure and improve operating performance when one of the firms in the industry is subject to a takeover attempt.

The results indicate that rival firms in general decrease free cash flows, improve operating performance, reduce capital expenditures and increase leverage in response to a control threat within the industry. In particular, rival firms with potentially higher agency costs i.e. fewer investment opportunities and high cash or high free cash flows exhibit a higher reduction in cash levels and free cash flows subsequent to a control threat in their industry. These results are consistent with the inefficient management hypothesis, which suggests poorly performing firms are more likely to be the target of a takeover attempt and the acquisition probability hypothesis proposed by Song and Walkling (2000), which states that rivals of initial targets earn abnormal returns because of an increased probability that they themselves will be targets. These results lend support to the argument that takeovers act as an effective external control mechanism for managers and that they have industry wide effects.

JEL: G34 KEYWORDS: Mergers, takeovers, industry rivals, agency costs

INTRODUCTION

C urrent research documents that industry rivals of takeover targets earn significant positive announcement period abnormal returns. The traditional explanation for these positive abnormal returns has focused on changes in the level of competition within the industry. However, more recently Song and Walkling (SW) (2000) propose and find support for the acquisition probability hypothesis, which states that the rivals of initial targets earn announcement period abnormal returns because of increased probability that they themselves will be targets. The focus of their investigation is on the market performance of rivals. Existing literature suggests that the removal of inefficient management to improve operating performance is one of the key underlying motives for takeovers commonly referred to as the inefficient management hypothesis. Thus, the acquisition probability hypothesis and inefficient management hypothesis together suggest that poorly performing firms are more likely to be the target of a takeover attempt following an initial takeover announcement in their industry.

This paper investigates, when a firm is subject to a takeover attempt; whether the managers of industry rivals act to mitigate their agency exposure and improve operating performance to reduce probability of being themselves subject to atakeover attempt. Specifically, this research investigates whether rivals with high levels of cash and free cash flows coupled with a low Tobin’s q (few investment opportunities), low (or high) managerial ownership, low institutional holdings, lower external monitoring by debt holders and poor operating performance (1) reduce excess funds; (2) reduce capital expenditures; (3) lower their operating expense and (4) increase their leverage.

The results indicate that rival firms in general decrease cash levels and free cash flows, reduce capital expenditures, reduce operating expenses and increase leverage in response to a control threat in the industry. In support of agency arguments, results indicate that rival firms with few investment 97 R. Paliwal  The International Journal of Business and Finance Research ♦ Vol. 4 ♦ No. 2 ♦ 2010 opportunities and high cash or high free cash flows reduce cash levels and free cash flows significantly subsequent to a control threat in their industry. Furthermore, rivals with high managerial ownership (entrenched managers) increase leverage and reduce free cash flows in response to a control threat. The results also indicate that those rivals that increase leverage in response to control threat also reduce their cash levels and cash flows. Rival firms with low Tobin’s q reduce cash levels, increase leverage and improve asset turnover.

Overall, the evidence supports the argument that takeovers act as an effective external control mechanism for managerial agency behavior and that they have industry-wide effects. Rival firms take steps to reduce their agency exposure and improve operating efficiency in response to a control threat, regardless of the form (horizontal or non-horizontal) and type (hostile or friendly) of the initial takeover.

The research here complements the findings of Servaes and Tamayo (2007) and Song and Walkling (2000) and other papers examining industry-wide effects of control threat. While Song and Walkling (2000) focus on abnormal returns to rivals, Servaes and Tamayo (2007) focus on financial policy variables. Servaes and Tamayo (2007) find that rival firms increase leverage, cut capital expenditures and reduce their cash balances and free cash flows. However, their sample is restricted to the rivals of 218 firms, which receive hostile takeover bids during the period 1983-1998. They focus only on rivals of hostile takeover attempts, as agency problems are likely to be the primary motive for control threat for these firms. They suggest that other firms may have been takeover targets for synergistic reasons unrelated to agency problems, and their rivals may not respond. However, Schwert (2000) concludes that hostile takeovers are not distinguishable from friendly takeovers, which justifies the use of an expanded sample in the research presented here. This study extends their work by (i) covering a much larger and broader sample of takeovers of all types (ii) examining operating performance in addition to the financial policy characteristics and (iii) specifically taking in to consideration investment opportunities, managerial ownership, institutional holdings and level of industry concentration of rivals.





The remainder of the paper is organized as follows. The first section presents background literature and develops hypotheses. The second section describes the data and methodology and the third reports results from the univariate analysis of the full and several sub-samples. The fourth section reports results from a cross-sectional analysis. Section five concludes the paper.

LITERATURE REVIEW AND HYPOTHESES

The positive association between acquisition announcements and stock price movements of rival firms in the same industry as a takeover target has been documented in several studies (See Eckbo (1983, 1985), Stillman (1983), Banerjee and Eckard (1998), Akhigbe, Borde, and Whyte (2000), Mitchell and Mulherin (1996)). The traditional explanation for positive announcement period abnormal returns focuses on horizontal mergers and argues that such mergers decrease competition, thereby encouraging collusion among the remaining firms in the industry. However, the existing empirical literature does not find support for this argument. Song and Walkling (2000) provide an alternative explanation for the rivals’ positive announcement period abnormal returns. They propose that the rivals of initial targets earn abnormal returns because of an increased probability that they themselves will be targets. They term this argument as the “acquisition probability hypothesis.” Song and Walkling (2000) find that on average rival firms earn positive abnormal returns regardless of the form and outcome of the acquisition. They also find that rivals’ abnormal returns in the announcement period are higher for rival firms with higher probability of acquisition. In addition, rivals who subsequently become targets earn significantly higher abnormal returns in the announcement period.

Another implication of the acquisition probability hypothesis is that following an initial takeover announcement rival firm managers may take steps to reduce their agency exposures i.e., their potential to 98 The International Journal of Business and Finance Research ♦ Volume 4 ♦ Number 2 ♦ 2010 overinvest and consume excess perks to avoid being subject to a takeover attempt. This paper investigates whether the managers of rivals act to mitigate their agency exposure when one of the firms in the industry is subject to a takeover attempt.

Earlier research has documented that takeover targets usually have small size, low growth rate, low Tobin’s q, low (or high) managerial ownership and a low level of outside block holder ownership.

Hasbrouck (1985) concludes that the average q–ratio of acquired firms is significantly lower than the average q-ratio of control groups matched by size or industry. Lang, Stulz and Walkling (1989) find that for successful tender offers, target, bidder and total returns are larger when targets have low q ratios and bidders have high q ratios. Servaes (1991) uses a broader sample and confirms that these results hold for both mergers and tender offers. Jensen (1976) argues that a firm with excess free cash flows will have a tendency to overinvest by undertaking marginal investment projects with negative net present values. An increase in dividends by such firms will reduce overinvestment and increase market value of the firm.

Consistent with this argument, Lie (2000) documents a favorable market response to large special dividends and self tender offers when the announcing firm has potentially large agency problems as indicated by high cash levels coupled with poor investment opportunities (indicated by low Tobin’s q).

More recently, Shahrur (2005) reports significant positive abnormal returns to rivals’, suppliers and corporate customers of merging firms, thus documenting industry-wide effects of horizontal takeovers.

Bris and Cabolis (2003) find that the Tobin’s q of an industry increases when firms in that industry are acquired by firms from countries with better shareholder protection and accounting standards. This result implies that the adoption of better corporate governance practices by one firm has industry-wide effects.

Berger and Ofek (1999) and Denis, Denis and Sarin (1997) argue that firms that implement corporate refocusing programs often do so in the presence of external control pressures such as a takeover threats.

Therefore, I hypothesize that: after an initial takeover attempt in the industry, rival firms with high levels of cash and free cash flows coupled with low Tobin’s q, low, or high, managerial ownership, low institutional holdings, lower external monitoring by debt holders and poor operating performance will reduce their excess funds – a primary symptom of agency costs.

Williamson (1963) argues that managers do not have a neutral attitude towards costs. Managers have what he describes as expense preference i.e. certain class of expenditures have positive value associated with them. Specifically staff expenses, expenditure for emoluments and funds available for discretionary investments have value in addition to that deriving from productivity. He argues that mangers may choose to shirk and indulge in excessive perquisite consumption. He also observes that the expansion of physical plant and equipment is also subject to managerial discretion. Takeovers are considered one of the key mechanisms, which can act as a check against such managerial discretionary behavior. Healy, Palepu and Ruback (1992) observe a significant improvement in industry adjusted asset productivity for the combined firm, which leads to higher operating cash flow returns. Trimbath, Frydman and Frydman (2002) conclude that cost inefficiency is a determinant of the risk of being a takeover target. Therefore, I hypothesize that: after an initial takeover attempt in the industry, rival firms with high levels of cash and free cash flows coupled with low Tobin’s q, low, or high, managerial ownership, low institutional holdings, lower external monitoring by debt holders and poor operating performance will improve their operating efficiency with lower operating expenses, and reduce their capital expenditure.

Jensen (1976) also argues that when managers issue debt in exchange for stock, they are bonding their promise to payout future cash flows that cannot be accomplished by a simple dividend increase. Thus, additional debt reduces the agency costs of free cash flows by reducing cash flows available for spending at the discretion of managers. Safieddine and Titman (1999) find that on average targets that terminate takeover offers significantly increase their leverage ratio. These targets which increase their leverage ratio also reduce their capital expenditure, downsize in terms of assets and employment and their cash flows and their stock returns outperform the benchmark in the following 5 years. Based on this evidence 99 R. Paliwal  The International Journal of Business and Finance Research ♦ Vol. 4 ♦ No. 2 ♦ 2010 they argue that an increase in leverage by a target in response to a takeover attempt is not a defensive mechanism but it increases the credibility of a target manager’s promise to improve performance. Lang, Ofek and Stulz (1996) document evidence suggesting that increased debt induces firms to invest less, especially for firms with low q. We expect similar behavior from the rivals of targets. Therefore, I hypothesize that: after an initial takeover attempt in the industry, rival firms with high levels of cash and free cash flows coupled with low Tobin’s q (few investment opportunities), low (or high) managerial ownership, low institutional holdings, lower external monitoring by debt holders and poor operating performance will increase their leverage.

DATA AND METHODOLOGY



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