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Acquisitions and Funding Conditions

April 26, 2022

Investor Activism

A study at Drexel University’s LeBow College of Business shows that greater availability of capital funding in the U.S. economy increases the number of small bidders in the market for Mergers & Acquisition (M&A) and affects the relative quality of bids. Under favorable aggregate funding conditions, the market reaction to an M&A announcement suggests that smaller bidders are viewed by investors as value-adding while larger bidders are seen as value-reducing.

Key Insights

  • When aggregate capital availability is favorable in the U.S. economy, the pool of potential bidders in the M&A market includes more small firms. Moreover, the average merger announcement return across all firm sizes in favorable conditions is 25% higher compared to periods of unfavorable capital availability.
  • During favorable aggregate funding conditions, small bidders increase their M&A activity by 77%, suggesting that financial constraints prevent them from participating in M&A deals when capital is tight in the economy. The average merger announcement returns on M&A deals undertaken by small bidders is positive regardless of the aggregate funding conditions, however, it is significantly higher when capital is plentiful.
  • During favorable aggregate funding conditions, large firms increase their M&A activity by only 4%, suggesting that their ability to participate in the M&A market is not significantly affected by capital availability in the economy. However, the average merger announcement returns on M&A deals carried out by large bidders are negative under favorable funding conditions and positive under unfavorable conditions. Since the negative investor reaction is sharper for firms that are likely to have more agency problems, this finding indicates that, when capital is plentiful, large bidders tend to misuse available funds and overinvest.

Summary of Complete Findings

It is well known that an individual firm’s financial condition impacts its ability to undertake mergers and acquisitions (M&A). This study provides evidence that macroeconomic funding availability can also change the nature of the M&A environment in the U.S., as both the type of bidder (small vs. large) and the investor reaction to an M&A deal depend on the overall availability of capital in the economy.

The analysis uses a sample of over 31,000 mergers and acquisitions across 36 years to examine changes in the pool of bidders and changes in the market returns for deals enacted under two different aggregate funding states: favorable and unfavorable. The funding environment is defined as favorable (unfavorable) when the most recent change in both the Federal Discount Rate and the Effective Federal Funds Rate is a decrease (increase). The funding environment is defined as indeterminate when the two rates move in opposite directions. The market return is the bidder stock return observed when a bidder announces an acquisition or merger attempt.

In the study, small bidders are firms with the 25% lowest book asset value in the sample and large bidders are firms with the 25% highest book asset value. All firms are public.

The first critical finding is that large bidders undertake a similar volume of M&A deals across the two funding states with just a 4% increase during favorable funding conditions. However, for small bidders there is a dramatic increase of M&A activity (77%) during favorable aggregate funding conditions compared to unfavorable conditions. Moreover, the majority of small firms only conduct deals in favorable funding environments and never announce a single transaction in an unfavorable state. This striking difference in the ability of these two types of bidders to access the M&A market points to the importance of monetary policy in influencing participation and competition in M&As.

During favorable funding conditions, the average announcement return is 25% higher than during unfavorable conditions. This result is mainly driven by the higher return for deals undertaken by small firms. The market, therefore, signals that a larger pool of small bidders leads to more value-adding deals.

The study then finds that the size of a bidder affects the relation between aggregate funding conditions and announcement returns. In particular, it documents negative announcement returns for large bidders during favorable funding conditions and positive returns for large bidders during unfavorable conditions. It also shows that, although announcement returns are always positive for small bidders, the returns are significantly higher during favorable conditions.

The observed difference in market returns signals that investors view M&A deals carried out by small firms as value-creating regardless of funding conditions. They also tend to attribute a positive value to M&A deals by large firms only in unfavorable funding environments.

To interpret these findings, the researchers explain that small bidders might be seen as having better synergistic opportunities with potential target firms. As a result, when these small bidders are in the pool, large firms need to “overpay” in order to outcompete the small bidders and close the deal. Conversely, under unfavorable aggregate funding conditions, large firms encounter less competition because small firms are less able or willing to engage in M&A deals. The reduced competition potentially allows large bidders to acquire firms at a relative discount and avoid overpaying for the target.

The impact of the funding environment on the returns of M&A deals enacted by large bidders is more pronounced when the size of the target firm and the cash flow available to the bidder is larger. The size of the target and the level of cash flow are used in the study to gauge whether a firm is more likely to have agency problems (i.e. management’s propensity to seek personal gain rather than shareholder value). Larger bidders may focus more on empire-building rather than shareholder value. Similarly, when a firm has plenty of available cash and low growth opportunities, managers may overinvest in projects with marginal or even negative net present value. Poor corporate governance could explain why investors expect deals involving big targets and large cash flows to reduce value for shareholders.

This study builds an interesting bridge between macroeconomic fundamentals and the individual actions of participants in the market for M&As. In doing so, it highlights a monetary policy trade-off between enabling a healthier competition in the M&A market and prompting some poor (and potentially large) deals. Specifically, the study suggests that favorable funding conditions (enabled by an expansive monetary policy) are particularly beneficial for the smallest, most constrained firms. However, it also shows that there is a potential negative outcome from having too much readily available capital, as larger firms tend to overinvest when funds are easily accessible.

“Acquisitions and funding conditions” by David Becher (Drexel University), Tyler K. Jensen (Iowa State University), Tingting Liu (Iowa State University), was published in the Journal of Corporate Finance, December 2020.
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