M&A Winners Don’t Always Prosper

Amid high stock prices, a good US economy and still-robust credit markets, we expect to see a lot more M&A activity through the balance of 2018. And not just among media companies, but across the industrial spectrum. How then can investors profit from more deal-making? A study in the August edition of the Review of Financial Studies suggests shareholders can benefit by sticking with companies that lose out in a bidding war over the acquirers.

Researchers at the University of California, Berkeley and the University of Amsterdam looked at close bidding contests of publicly listed companies in North America, Europe and Asia between 1985 and 2012. They then measured the stock returns of the winners and losers during the 3 years before and after the “merger contest”. Here were the results:

• Losing and winning bidders experience similar returns leading up to the merger announcement: “Stock returns of bidders in close contests are not significantly different before the merger contest”.

• Losing bidders outperform in the years following the decision: “The estimated effect for U.S. mergers is economically large, a 23.3% to 33.2% difference in buy-and-hold abnormal returns over the next 3 years relative to winners”. Outside of the US, “contested mergers generate less underperformance. [They] estimate a statistically significant effect of 13.6% in the international sample.”

• Shareholders of winning bidders don’t gain from the merger: “winners display no or negative abnormal performance after the merger… the shareholders of the acquiring company would have been better off under the hypothetical counterfactual in which their company lost the merger contest.”

So are there any telling indicators of a winning bidder likely to underperform? Look out for acquirers using cash and more leverage to get the deal done: “The negative merger effect is estimated to be particularly large in acquirers who spend their cash or bump up their leverage to finance the merger.”

To wrap up, here are our takeaways:

• These results make sense to us, M&A activity rarely covers its cost of capital. Last year, for example, S&P Global Market Intelligence Quantamental Research released results to a study that looked at deals from 2001-2017 and found acquiring companies’ shares lagged the market and rival firms in their industries. You can read more about it here in The Economist.

• The study’s outcome may indicate that investors see the losing company as a potential takeover target in the years following their lost bid. M&A activity is most common in consolidating industries, so the losers go from being the hunter to the hunted.

• In terms of what to do with this information, investors who want to profit from deal-making in contested mergers are likely much better off overweighting/taking positions in losing bidders. It’s counter-intuitive (“I want to own the winners in consolidation!”), but the data is compelling.

Paper: https://academic.oup.com/rfs/article/31/8/3212/4917575#118693994