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Impacts of Mergers & Acquisitions on Shareholder Wealth

This dissertation attempts to investigate, the impact of Mergers & Acquisition (M&A) on shareholder wealth in the European banking industry from 2003-2007 and explains in depth detail of the literature reviewed by the author to provide the basis of the successful achievement of the project. M&A has been a popular research topic in finance with broad literature exists on M&A. For this review to be achievable, a broad search for information was undertaken by means of the internet and library. The research question will examine the wealth effects (abnormal returns) of M&A involving European banks using `event study` methodology over the period of 2003-2007 in both the announcement period and long run post acquisition period. In other words, can M&A improves or destroy shareholder wealth of the targets, bidders and combined firms.

1.2 Introduction

The decade of 1990 saw the biggest increase in European M&A activity. Merger & Acquisitions (M&A) have been a significant phenomenon in the Europe. and the world economy which symbolizes one of the most important strategic decisions made by managers and shareholders of the engaged firm. Sudarsanam (2003,para1,p.1) argues shareholders and managers may be the most important stakeholders in M&A but other groups such as workers, competitors, lenders, customers all have a collective interest in this activity.

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M&A may be undertaken in order to replace an inefficient management, but sometimes two businesses may be more valuable together than apart. Motivation behind the mergers is to maximise the shareholders wealth. However, according to Jensen and Ruback (1983) and Sirower and O`byrne (1998), in almost two third of cases, mergers produce wealth gains for target shareholders and more or less zero gains to acquirers. Various studies have found that, usually the announcement of bank mergers neither create nor destroy shareholders value Pilloff and Santomero (1998). Also, some studies indicates that the announcement of certain types of bank mergers do create value, if that merger reduce costs.

Berger, Demsetz, Strahan (1999) identified five fundamental dynamic factors that motivate corporate takeovers i.e. an increase of globalization, technological progress, financial deregulation, changes in customer demand and the integration of financial markets. Arnold (2005, para2, p.1041), defined mergers as the combining of two business entities under common ownership whereas Bruner (2005) states it as consolidation of two firms that creates a new entity in the eyes of the law.

According to Investorwords.com acquisition is a acquiring control of a corporation, called a target, by stock purchase or exchange, either `hostile` or `friendly` which also be called takeover. E.g. in October 2007, Royal bank of Scotland (RBS) merged with Dutch bank ABN Amro to clinch Europe’s biggest ever banking takeover with 86% of ABN Amro’s shareholders accepting a 71bn euro (Ft.com). Bruner (2005) argues takeover activities are strategic transactions that could turn out to be an excellent investment of capital and resources.

1.3Merger waves

Nowadays, M&A is well known fact that comes in waves according to evidence from Bruner (2005), Gorton, Kahl & Rosen (2005), Martynova & Renneboog (2006). Five individual merger waves were observed in the UK economy in the last century i.e. 1900`s, the 1960`s, the 1970`s, the 1980`s and the 1990`s. (Kastrinaki, Stoneman 2007)

Brankman, Garretsen, Van Marrewijk (2008) argues that, in terms of economic importance, the dominant merger wave unpredictable is the positive global outcome, suggesting that M&A waves are an economy wide global phenomenon. The wave of bank mergers has been established to explain the diverse theories e.g. the `efficiency hypothesis` expect that mergers improve efficiency and help poor banks to survive as competition becomes increasingly rigorous in the banking industry. Gugler, Mueller, Yurtoglu (2004) finds that merger waves can be implicit if one identify that M&A do not boost efficiency and doesn’t increase shareholders` wealth but instead sited that M&A waves are best come across as the answer of overvalued shares and managerial opinion.

1.4Why do M&A occur?

In various European countries, mergers have allowed banks to increase efficiency by assisting the coordination of the closing of branches. Banks shareholders and managers need to recognize the potential sources of economic gain emerged from M&A. Banks can reduce costs and increase value in different ways e.g. diversification. I.e. if mergers generate cost synergies such as economies of scale, banks can reduce expenses.

According to evidence from Berkovitch & Narayanan (1993), Sudarsanam, Holl & Salami (1996), Hannan & Pilloff (2006), Martynova & Renneboog (2006), the motives for M&A have been categorised into the three main groups’ i.e. economic motive or synergy, managerial or agency problems and hubris. The actual distribution of merger gains between target and bidder shareholders will depend on their individual negotiating strengths. Therefore, following table shows the impact of mergers on shareholders wealth:

Merger Motive

Total Gains Target Gains Bidder Gains
Synergy + + +
Agency problems +
Hubris 0 +

1.4.1 Synergy Motive

The first key group that accounts for M&A is an economic or synergy motive which means that two companies can achieve together which they can’t achieve single-handedly. Siems (1996) argued that synergy theory projected that the acquiring bank can efficiently create synergies via economies of scale and scope by reducing costs and eliminating redundancies and duplication.

Economies of scale occurs when the average unit cost of production declines as volume increases e.g. banking mergers in the UK of Bank of Scotland and Halifax of 30bn merger in May 2001, to create HBOS fifth major force in UK banking sector. The idea was that the Bank of Scotland was operating in north of the country and Halifax was in south by merging these two banks, were trying to reduce cost of processing banking transactions. Economies of scope occurs when the cost of producing several products in a multi product firm is lower than the cost of producing the same products by individual firms e.g. Banc assurance model, British banking and issuance giant Lloyds TSB acquired Scottish Widows in June 1999 for 7bn.

Sudarsanam et al (1996) identified the sources of value creation into three main type’s i.e. operational synergy, managerial synergy and financial synergy. Operational synergy occurs during the recognition of economies of scale and scope, vertical integration, the elimination of duplicate activities, the transfer of knowledge or skills by the bidder’s management team and a reduction in agency costs by bringing organization precise assets underneath common ownership (Ravenscraft & Scherer 1987, 1989 cited in Martynova & Renneboog 2006).

Sources of value in vertical mergers includes reducing transaction costs in which combining different stages of the production chain can reduce costs of communication and bargaining i.e. one company’s output is other company’s input and by putting together will make the business efficient. E.g. Microsoft bid for Yahoo in January 2008, worth $42bn that will create more powerful browser or have a better chance of tackling the internet search leader. Having said that, current trends towards outsourcing suggest that, the benefits from vertical mergers are limited. According to Martynova & Renneboog (2006), establishments of operating synergies reduce production & distribution costs and yielding an incremental cash flow accruing to the company’s post-merger shareholders.

Sudarsanam et al (1996) argues managerial synergy could occur if the bidder has a competent managerial team and takes over a target with fewer competent managers. Such takeover is disciplinary and likely to improve the wealth gain for both bidder and target shareholders. Having said that, there is a considerable risk of agency problems where the managers do not operate in the interest of shareholders.

Martynova & Renneboog (2006) argues that diversifying takeovers are likely to gain from financial synergies in which financial synergies may incorporate improved cash flow stability, cheaper access to capital, an internal capital market as well as contracting efficiencies created by a reduction in managers’ employment risk. Conglomerate mergers allow risk diversification by spreading the income stream of the holding company over a wide variety of products and markets. Sudarsanam et al (1996) finds that financial synergy materialize from three likely sources i.e. the tax advantage of unused debt, the growth opportunities and financial resources of the emerging companies and the coinsurance of debt of the two companies which result in lower costs of capital.

1.4.2 Agency factor

The second main motive for M&A is managerial or agency factor. Shareholders are Principals i.e. owners of company’s assets and managers are employed as shareholders’ Agents to manage these assets on their behalf. Managers should make decisions that are consistent with the objective of maximize the shareholder wealth, but managers do not share this objective necessarily. Managers will have their own personal objectives which will be mainly concerned with maximizing their own welfare (Sudarsanam et al 1996). Therefore, managerial decisions in acquisitions may result in agent costs that reduce the total value of the joint firm as they do not maximise but weaken shareholders return.

Berger, Demsetz, Strahan (1999) argues that one managerial intention may be empire-building. Executive compensation leads to increase with company’s size, so managers may wish to accomplish personal financial gains by engaging in M&A, although at least in part the higher observed compensation of the managers of larger institutions rewards greater skill and effort. To protect their firm-specific human capital, some managers may also try to reduce insolvency risk below the level i.e. in shareholders’ interest possibly by diversifying risk through M&A movement. Arnold (2005) observes that the managers may enjoy the thrill of the merger process itself and as a result push for such deals to take place.

1.4.3 Hubris

The third and final main motive for M&A is Hubris which was specified by Richard Roll in 1986. Arnold (2005, para2, p.1055), define hubris as over weaning self confidence or, less kindly, arrogance. The hubris hypothesis states that the valuation of target by the bidder management is over optimistic and per se the bidding firm’s management overpays for the target. This perhaps for a number of bases such as decisions makers believing themselves, that the value exists when it does not or that their valuation is correct and that the market is not shimmering the full economic value of the combined firm. These managers may perhaps be overconfident or have misplaced faith in their ability to develop the profit performance of the target firm. Berkovitch & Narayanan (1993) argues that the hubris maintains that decision makers in the bidding firms simply pay too much for their targets as a result of mistakes in overestimating the value of the targets.

1.5 Factors influencing shareholder returns

Shareholders returns are not just affected by M&A announcements, but they are also influenced by bid characteristics e.g. method of payment, cross border M&A, friendly vs. hostile bids etc.

1.5.1 Method of payment

The method of payment is one of the key variables that must be agreed between the buyer and seller to determine the firms` abnormal returns and overall outcome of the bid. According to Huang and Walkling (1989), The form of payment will influence bidding strategy if it affects the anticipated NPVs of an acquisition. Huang and Walkling found that when method of payment and degree of conflict were taken into account statistically, abnormal returns were no higher in tender offers than in mergers. Payment methods can affect NPVs through interrelations with either acquisition cost or the probability of success or both whereas Dube, Glascock & Romero (2007) argues that the different stages of benefit growing to the target and acquiring firm’s shareholders is attributed to the alternative methods of payments.

Arnold (2005, para1, p.1059) states that cash payment has been the most popular and most valued method of payment which offers higher return than equity. For example, bidding firm is expected to carry out stock financed merger if the management of bidding firm has better-quality inside information that the existing assets of the firm are overvalued. However, if the bidder firm has confidential information about the target company and trusts it to be undervalued, then it probably offer cash financed merger.

Therefore, merger financed with stocks are a negative signal because the use of stocks as a method of payment is more likely to occur when the stock is overvalued, while the use of cash is taken as the firm being overvalued. Alternatively, if target shareholders consider that their bank is overvalued, they will prefer to receive cash. This theory is supported by empirical literature and it demonstrates that at the time of the bid announcement acquirers who propose cash, tend to practice higher abnormal returns than those who offer stock financed merger.

The advantage of cash is that the acquirer shareholders hold the same level of control over their company because their proportion of ownership has not been diluted by giving target shareholders stock options in the merged company. Therefore, the returns to the shareholders of a bidding firm will be higher in cash financed merger than the stock. Brealey, Myers & Marcus (2004, para1, p.599) states if cash is offered, the cost of the merger is not affected by the size of the merger gains. And if stock is offered, the cost depends on the gains because the gains show up in the post merger share price, and these shares are used to pay for the acquired firm.

1.5.2 Cross border M&A

The combination of worldwide financial markets has been going together with, increases in the number and tiny proportion of firms that operate in the global market and the globalization process has been to a rational extent encouraged by cross border M&A. According to Brankman, Garretsen, Van Marrewijk (2005, 2008) cross border M&A are the main medium for foreign direct investment. M&A provides fundamental but also limited understanding of this form of takeover, as cross-border M&A are most likely related to economy-wide shocks such as economic integration, changes in the legal and regulatory environment or likely asymmetric business cycles.

Based on past empirical evidence, though the majority of the domestic M&A create significant wealth gains for the targets and negative or zero returns for bidders, cross border M&A could have different impact on related firms. Kang (1993) stated that cross border M&A are expected to create more wealth than domestic ones because of existence of market imperfections which leads to guide multinational firms (MNC) having a competitive advantage over local firms. Foreign banks have to act in accordance with with both regulations at home and abroad; domestic credit establishments have cost advantages, since fulfilling two diverse sets of regulation enforce additional costs on foreign banks.

Also, different regulations reduce the amount of related fixed costs. This decreases the possibility for banks to collect benefits from economies of scale and scope. Economies of scale propose that bank is able to reduce its costs by growing the volume of output of products and services it already produces. As a result of developing into new country, a bank increases its potential client base and benefits from economies of scale. According to economies of scope, banks that diversify activities could reduce costs by providing more services.

1.5.3 Friendly vs. hostile bids

Analysis regarding the impact of hostile takeovers has been arguable, varying from the benefits of market discipline for maximizing efficient utilization of resources to the damage of market shortsightedness on the economy, on the society and on value built over years. Dube, Glascock & Romero (2007) argues such debates can impact financial marketsand can be expected to expand as developing markets open up to foreign corporations and as economic power is redistributed amongst countries. Hostile takeovers occur, when the management of a firm resists the takeover attempt by bidders. Lambrecht and Myers (2007) state that in some cases a potentially hostile acquirer could be better off negotiating with the target management for a merger and that such a situation reduces the power of the target shareholder to extract value from the bidder. Hostile acquisitions also involve swifter and more drastic changes in target. In both friendly and hostile acquisitions, overpayment can arise due to agency reflection of managerial objective maximization by the acquirer management.

Goergen and Renneboog (2003) analyzed the market reactions to the different types of takeovers i.e. friendly, hostile and bids with multiple bidders. They found that hostile bids created the largest abnormal returns for the target i.e. 13% on the announcement day. When a hostile bid is made, the share price of the target straight away reflects the expectation that opposition to the bid will guide to upward revisions of the offer price. Various empirical studies have found that the returns to bidders in hostile takeovers are negative; resulting in low possibility of success of a hostile bid.

1.6 Impact of M&A on shareholders

Almost all of the studies of M&A in banking industry are based on US data. As we know, one of the main objectives of mergers is to maximise the shareholders value by the means of increase in dividends and increase in share prices, so the shareholders can enjoy the capital gains. The two most important methods which can be used to assess the impact of M&A were explained by Firth in 1980. In the first method, accounting information is used to determine the firms` financial performance & profitability. The second method believes in efficient market which can be used in share price movements to estimate the economic impact of the event. The second method, direct measures any increase or reduction in shareholders wealth but also experience from the reality that no market is really efficient which results to mislead conclusions due to movement in share price.

In this project, author chose the second method i.e. an event study in which the focal point will be on three different sets e.g. the target, the bidder and the impact of M&A on combined firm in the long run. Various empirical studies on M&A have concentrated on establishing stock market reaction around the announcement of a deal and whether a merger creates value for the shareholders of target and bidding firm.

Delong (2001) examined 56 banks between 1991 and 1995, for focusing mergers that create positive abnormal returns whereas diversifying mergers produce negative abnormal returns. DeLong (2001) has point out that upon announcement the market responds positively to mergers that focus both on the activities and geography, which is consistent with Siems (1996). Delong finds that the cumulative abnormal returns (CAR) of target firm has been increased to 14.8% after merger and the bidding firm loose a significant 2.2%, whereas the combined firm neither created nor destroyed the shareholders value. The result also shows that the long term performance is improved when mergers involve inefficient bidders, payment not just made by cash and earnings are not diversified.

Cybo ottone and Murgia (2000) analysed 54 largest M&A deals with CARs at +3,41% between 1988 and 1997 on the European banking sector in 14 European markets. They have found that at the time of announcement, there was a positive and an important increase in the market value of the banks engaged in these deals. They have found positive abnormal returns for both buyers and the sellers using the general market index in the short period of eleven days, but found negative market reaction to acquiring bank. In other words, European bank mergers generate value for the combined firms including the target and the bidders do not lose. Various studies have shown that in Europe and the USA, target shareholders earn positive abnormal returns from mergers.

Cyboottone and Murgia (2000) stated that bidding firm shareholders earn positive abnormal returns in European studies whereas in USA studies bidding firm shareholders earn negative abnormal returns from the mergers. Shareholders of target European banks achieve more than the bidding bank shareholders, however, the difference is very tiny indeed. So in other words, we can say that Cyboottone and Murgia (2000) results are not consistent with the USA banking literature which shows that no value creation effects are usually found.

Martynova and Renneboog (2006) examined the short term wealth effects of 2,419 European M&A announcements between 1993 and 2001 in twenty eight European countries. They found that UK target created higher returns (9%) and UK bidders experienced lower wealth losses (0.5%) in comparison to the total European average result. They also identified the share price reaction of bidding firms; on a hostile merger i.e. it generated a negative abnormal return of -0.4%, on the other hand, a friendly acquisition created a positive abnormal return of 0.8%. Therefore, Martynova and Renneboog (2006) have concluded that M&A do create value for the bidding and the target shareholders in which target shareholders enjoy majority of gains as they collect large premiums.

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Beitel (2001) look at 98 large M&A of European banks between 1985 and 2000 using the event study in which he found out, the shareholders of the target firm enjoy positive cumulative abnormal returns (CAR), whereas the shareholders of the bidding firm doesn’t earn any CARs. However, the combined analysis of bidding and target European bank merger do create the shareholders value significantly. They also notice a change in the results after 1998 that European bidding banks in large deals experienced negative CARs and especially cross border mergers of European banks appeared to have destroyed shareholders value.

Table 1: Summary of bank mergers using event studies of previous Abnormal Returns to shareholders

M&A studies Sample period Sample size Event Window Target CARs (%) Bidder CARs (%)
Antoniou, Arbour & Zhao (2006) 1985-2004 396 -2 to +2 17.37 -3.32
Cybo-ottone & Murgia (2000) 1988-1997 54 -10 to 0 16.1 Not significant
DeLong (2001) 1988-1995 280 -10 to 1 16.61 -1.68
Sudarasanam, Holl & Salami (1996) 1980-1990 429 -20to+40 days 29 -4
Becher (2000) 1980-1997 553 -30 to +5 22.64 -0.1
Siems (1996) 1995 19 -1 to +1 13 -2
Houston & Ryngaert (1997) 1985-1991 184 -2 to +2 20.40 -2.40

Ismail and Davidson (2005) studied 102 merger announcements in European banking industry between 1987 and 1999. They found positive abnormal returns for targets and the return to bidders differs across the deal type, also the merger deals earn higher returns than acquisition deals. They reported that the high competition in the market and reduction in the profitability in the banking industry in Europe is extending a depressing picture of performance of the future. They also reported low positive abnormal returns to target shareholders compared to other findings in the banking industry in Europe. The reason behind is that the bidder not ready to pay higher premiums in a competitive environment in which level of profits are decreasing. Ismail and Davidson (2005) pointed out that if equity is used as a method of payment instead of cash, then merger deals earn lower returns because of the fact is that equity signal to the market that the equity is overvalued which is consistent with findings of Huang and Walkling (1987).

1.7 Conclusion

A bank acquires another bank because of number of reasons e.g. diversification, market power, managers preference etc. This literature review looks at the motives of M&A based on the past academic studies i.e. Berkovitch & Narayanan (1993), Sudarsanam et al (1996), Hannan & Pilloff (2006), Martynova & Renneboog (2006). Having said that, it is still not clear whether synergy gains or personal quest of managers is behind motivating majority of M&As. Evidence suggests that the managers may use the free cash flow for mergers that may produce negative NPV investments, because managers pursue their own interests rather than those of shareholders, resulting in mergers to not create value for shareholders.

Whereas hubris, which supports the efficient market hypothesis (EMH) suggests that any bid for the target at premium overpays and it is result of the hubris. Arnold (2005) state it is similar to `winner’s curse` where the highest bidder will bid typically higher than the expected value of the purpose. However, most of the evidence suggests that the target shareholders gain positive abnormal returns while the cumulative abnormal returns (CARs) to the bidders are significantly negative and the combined banking firms seems to improve the shareholders value. Various studies also supports the fact that target shareholders gain at the expense of bidder shareholders and bank mergers do not create value for the combined firm in stock market reaction to bank mergers. Also, evidence shows that shareholders returns are not only affected by the M&A announcements but they are also influenced by bid characteristics.

2.0 Methodology

2.1 Introduction

Choosing appropriate research methods are clearly vital. According to Veal (1997) it is important for the researcher to be aware of the range of methods available and not to make claims that cannot be justified on the basis of the methods used. This part of this dissertation gives an outline how information was collected, the sample design & statistics and which methodology is used by concentrating on European banking sector mergers between 2003 and 2007. Firstly, we have to decide the philosophy underlying this research, which involves choosing a paradigm. Collis and Hussey, 2003, p. 352 define paradi

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