Corporate Deal Performance Evaluation122

Corporate Deal Performance

1. Deal Performance Evaluation

2. Learning Objectives In this lesson, you are expected to: Understand the concept of shareholder value creation in mergers and acquisitions Measure short- term gains from the deal using event study

3. Different Perspectives of M&As Economic and strategic perspective – establish competitive advantage which should then lead to value creation for shareholders Finance perspective – the main objective is value creation for shareholders. Obstacles include principal- agent problems, weak corporate governance and market imperfections Organisational perspective – acquisitions are driven by intended organizational changes. However, these may not be always achieved Managerial perspective – M&As are the result of managerial incentives whose interests though may not be aligned with those of shareholders Presenter Notes 2022-09- 14 15:05:39 ------------------------------------------- - The economic and strategy perspectives suggest that mergers may be driven by economic and strategic logic that seeks to establish competitive advantage, leading to value creation for shareholders. The finance perspective proposes shareholder wealth maximization as the pre- eminent objective of merger decisions, although contextual factors such as principal–agent problems, weak corporate governance structure and an imperfect market for corporate control may cause deviation from this objective. The organizational perspective calls into question the assumption that acquisition decision process is a coldly logical process driven by considerations of economic rationality and shareholder value imperative. It also raises the possibility that the outcome of any merger may not deliver the ex ante merger objectives because of the difficulties in achieving the organizational change that is a precondition for their achievement. The managerial perspective, again drawing upon the agency model of the firm, points to managerial objectives that may conflict with shareholder objectives. Managerial incentives, designed to alleviate the agency conflicts, may also have perverse effects by encouraging managers to take more risk. The collapse of the stock markets and of the M & A waves in 2000–2001 have been attributed to such skewed incentives. These various perspectives suggest that merger outcomes may not always be beneficial to shareholders and other stakeholders.

4. Company Stakeholders Government Managers Shareholders Employees Community Consumers FIRM Presenter Notes 2022-09- 14 15:05:39 ------------------------------------------- - Nevertheless, mergers and acquisitions are of considerable interest to all the stakeholders in the merging firms. These include shareholders, managers, employees, consumers and the wider community. Thus assessment of the ‘success’ of mergers depends on the particular stakeholder perspective adopted. The interests of these groups do not always coincide. One group can win at the expense of the others. For example, a takeover can lead to high shareholder returns, but loss of managerial jobs. The antitrust authorities are the custodians of the interests of the consumers and the community at large, and regulate mergers and acquisitions. These competition authorities generally follow the rule that mergers that lead to substantial lessening of competition (SLC) should be prohibited.

5. Testing the Impact of M&As on Firm Value: Event Study Event studies are used to examine the impact of several corporate events such as M&As , IPOs, CEO turnover, earnings announcements, changes in capital structure, etc. They help address the fundamental question of how the flow of information to the market about an event affects share returns and assess the wealth impact of corporate changes For the above reasons, it is determined whether there is an abnormal return following an (unanticipated) corporate event Non- zero abnormal returns that persist after an event are inconsistent with the efficient market hypothesis (EMH). The EMH argues that prices adjust quickly to fully reflect new information

6. Measuring Post- Acquisition Performance: The Benchmark Problem The merged entity is not the same firm as the two firms preceding the acquisition Post- deal performance may not be directly comparable to pre-deal performance How would the merged firm perform if the acquisition had not taken place? The expected shareholder value improvements from the merger should be incorporated in the benchmark

7. The Benchmark Problem: Illustration Acquirer’s hypothetical stock- price performance Acquirer’s actual stock- price performance Stock Price Acquirer’s hypothetical stock- price performance Time Acquisition date

8. The Benchmark Problem: Possible Solutions Performance forecast – allows for expected changes in market conditions or competitive reaction but sensitive to the quality and reliability of analysts’ forecast Control sample – match the acquiring firm to a non- acquiring control firm or a set of control firms based on a number of characteristics. Example: CAPM (based on systematic risk) Additional variables such as industry, size and growth prospects (market- to- book ratio) Propensity- score matching (PSM) – matching the acquiring firm to a non- acquiring firm with a similar propensity to acquire (a probit regression model is usually required) Presenter Notes 2022-09- 14 15:05:40 ------------------------------------------- - CAPM: A firm that has the same systematic risk as the merging firms then provides a good control for estimating the post- merger performance. However, this procedure assumes that the systematic risk of the merged firm will continue to be the same as that of the control firm. This raises the question of whether the merger has altered the systematic risk profile of the merging firms. Strategic reconfiguration of firms often alters their risk profile. For example, a horizontal or vertical merger may change the cost structure, market share and volatility of earnings, thereby changing the risk profile. In this event the control may no longer be a valid benchmark if it does not undergo similar transformation

9. According to Capital Asset Pricing Model (CAPM), the expected return on stock i depends on its systematic (non- diversifiable) risk: E  r i   r f   i   E  r M   r f   where Calculating Abnormal Returns: CAPM 𝐸(𝑟 𝑖 ) = Expected return on share i 𝑟 𝑓 = Risk- free rate 𝛽 = Beta of share i 𝐸(𝑟 𝑀 ) = Expected return on the market portfolio Presenter Notes 2022-09- 14 15:05:40 ------------------------------------------- - A security’s price performance can be considered abnormal only with reference to some benchmark, and therefore it is necessary to specify a return- generating model before abnormal returns can be measured. If the actual return at the time of a merger exceeds the expected return, the excess or abnormal return ARit in time t for the stock of merging company i is a measure of the merger impact on the value of the stock to investors.

10. The abnormal return is difference between the actual (realised) return and the expected return AR i  r i  E  r i  where Calculating Abnormal Return: CAPM 𝐴𝑅 𝑖 = abnormal return on share i 𝑟 𝑖 = actual (realized) return on share i

11. Excess Returns on Size Portfolios 1926 - 2011 Presenter Notes 2022-09- 14 15:05:40 ------------------------------------------- - The plot shows the average monthly excess return (the return minus the one-month risk- free rate) for ten portfolios formed in each year (by Fama and French) based on firms’ market capitalizations, plotted as a function of the portfolio’s estimated beta. The black line is the security market line. If the market portfolio is efficient and there is no measurement error, all portfolios would plot along this line. The error bars mark the 95% confidence bands of the beta and expected excess return estimates.

12. Excess Returns on Book-to- Market Portfolios 1926 - 2011 Presenter Notes 2022-09- 14 15:05:40 ------------------------------------------- - The plot shows the same data with portfolios formed based on stocks’ book-to-market ratios rather than size. Note the tendency of value stocks (high book-to-market) to be above the security market line, and growth stocks (low-book-to-market) to be near or below the line.

13. Incorporating the size and growth factors in the CAPM, the model take the following form: E  r i   r f   i   E  r M   r f    h i HML  s i SMB where Abnormal Returns Extended CAPM (Fama and French 3- Factor Model) 𝑟 𝑓 = risk- free rate 𝐻𝑀𝐿 = difference in returns between high and low market-to- book value portfolios 𝛽 𝑖 = beta of share i 𝑆𝑀𝐵 = difference in returns between small and big firm portfolios Presenter Notes 2022-09- 14 15:05:40 ------------------------------------------- - This application of the Fama–French three factor (FFTF) model assumes that three factors are adequate to explain the observed returns. But Carhart found that there was another missing factor! This is the momentum in stock returns: that is, firms experiencing high returns in the past continue to earn high returns. But the last word has perhaps not been said on this matter, since finance researchers have been engaged in a search for what are quaintly described as ‘anomalies’. Other researchers have tried to explain asset prices by including, in addition to beta, size and book- to-market, other proxies for more obscure factors such as dividend yield, past performance or bankruptcy risk. Thus the enthusiastic search for the Holy Grail of the asset pricing model continues Both the FFTF and Carhart four-factor models are generally used to measure long term performance and are estimated using monthly returns.

14. The expected return on share i is given by the following equation: r i     1 r M where Abnormal Returns: Market Model The estimation period is usually 140 trading days (- 200, - 60) preceding the acquisition announcement date or a similar period 𝑟 𝑀 = Actual return on the market 𝛾𝛾 and 𝛾𝛾 1 = Estimate obtained by regressing the actual security return on the actual market returns over the estimation period Presenter Notes 2022-09- 14 15:05:41 ------------------------------------------- - The market model and the CAPM are related, and alpha can be related to the risk-free return and beta. Many early studies of stock market efficiency and the impact of numerous corporate events, such as acquisitions, dividend policy changes, accounting policy changes, new share issues and seasoned share issues, were conducted using the CAPM, the market model, or slight variations of these.

15. The market- adjusted model is a variation of the market model assuming that  is equal to zero. By definition, the beta of the market portfolio is equal to 1 Therefore, the model implies that the individual share i earns the same normal (expected) return as the market, that is, share i is the same as the average share in the market The model is also consistent with CAPM under the assumption that  i = 1 for all securities Abnormal Returns: Market- Adjusted Model

16. Short- Term Deal Performance: Cumulative Abnormal Returns (CARs) The market reaction to a M&A announcement is measured by the Cumulative Abnormal Returns (CARs) to shareholders over a short event window of a few days around the event: T where AR i , t is the abnormal return on share i on day t CAR i , t   AR i , t t  1

17. Short- Term Deal Performance: Cumulative Abnormal Returns (CARs) Therefore, using a 3- day event window: Usually, for a 3- day CAR we use the symbol CAR(- 1, +1) where - 1 is the date preceding the acquisition announcement, is the acquisition announcement date and +1 is the next day following the acquisition announcement 3  AR i ,1  AR i ,2  AR i ,3 t  1 CAR i ,3   AR i , t

18. So, What Have We Learnt? To determine whether the performance of short- and long- term performance of the acquisition, the event study is used Event study can be used to calculate abnormal return and cumulative abnormal return Abnormal return (AR) is excess return over and above return adjusted for risk (CAPM) Cumulative abnormal return (CAR) is the sum of daily return across a time period