Targeting Targets

November 08, 2022

M&A Drivers

Naveen Daniel, PhD, and Daniel Dorn, PhD, Associate Professors of Finance at Drexel University’s LeBow College of Business, investigate with a co-author the extent to which fund managers possess the ability to generate excess returns from investing in firms before they become targets for a merger or acquisition.

Key insights

Some mutual funds deliver positive and persistent Excess Targeting Return (ETR). The ETR is a novel measure of a fund manager’s targeting ability, which is defined as the return that active mutual fund managers generate when companies in their portfolio receive takeover offers, in excess of what they would have earned from the offers if they had passively held their benchmark portfolio.
A fund manager’s targeting ability consists in identifying individual stocks that will receive a takeover offer. Most significantly, this skill is not explained by governance failures, such as fund managers exploiting access to inside information on M&A deals through their connections with either investment bank employees or top management.
The ETR is economically significant and translates one-for-one into the gross return earned by investors above the benchmark return. It is not a compensation for risks associated with the portfolio allocation, but the reflection of a fund manager’s ability to pick stocks that are takeover targets, to hold more targets, to invest more capital in targets, and to select targets that receive a larger premium.

Summary of Complete Findings

Takeover targets receive large premia. Consequently, a mutual fund manager who invests in targets before they receive an offer will earn high returns. This study investigates whether some fund managers have a distinct ability to generates such returns systematically. The authors call this skill “targeting ability”. Their findings provide valuable insights on the governance of intermediaries such as actively-managed mutual funds.

The researchers investigate all takeover offers to publicly traded U.S. firms in the period 1985-2016, focusing the analysis on actively managed, domestic equity funds. They quantify targeting ability in terms of Excess Targeting Return (ETR). ETR is the targeting return of the fund minus the targeting return of the fund’s benchmark. The targeting return is the increase in fund value due to the takeover premium offered to the targets scaled by the value of the fund’s total equity holdings.

A positive targeting return does not, in itself, imply the fund has targeting ability because even an index fund will earn targeting return if stocks in the index receive takeover offers. In fact, if a fund chooses to mimic its benchmark, it would still earn some targeting return because of the stocks in the benchmark that received takeover offers. A fund’s distinctive skill lies instead in its ability to generate a targeting return in excess of what its benchmark earns.

If fund managers possess targeting ability, one would expect to see persistence in ETR, i.e. past ETR should be positively correlated with future ETR. To examine this hypothesis, funds are sorted into deciles according to their past performance: the 10 “funds-of-funds” are constructed to equally weight the ETRs of all funds included. The researchers find that fund-of-funds with higher past ETRs have higher future ETRs. The top fund-of-fund has also the highest future ETR, averaging 20 basis points per year. This is indicative of persistence in ETR.

A stricter definition of having targeting ability would require that funds with such ability also deliver positive ETR, not just higher ETR than their peers. Indeed, the top fund-of-fund exhibits positive future ETR 93 percent of the time.

Moreover, the top fund-of-fund in terms of past ETR is also classified as the top fund-of-fund in terms of future ETR 48 percent of the time. In terms of probability, this is highly significant when compared to just a 10 percent likelihood that a fund without targeting ability reaches the top. Consistent with this result, the top fund-of-fund in terms of past ETR is never classified as the bottom fund-of-fund in terms of future ETR. When comparing the subsequent performance of the top fund-of-fund to that of the bottom fund-of-fund, the study finds that the top fund-of-fund has a higher future ETR than the bottom fund-of-fund 97 percent of the time. Not only, 53.1 percent of funds that are past winners based on ETR are also future winners; but only 45.6 percent of past losers become future winners.

The persistence in ETR is confirmed for 29 years in the sample and ETR is positive in 16 years. Despite this pervasive persistence in ETR across time, one might expect stronger results during periods with high M&A activity because managers with targeting ability will have more opportunities to display their ability during such times. Accordingly, the study demonstrates that, while the ETR is persistent even in periods of low M&A activity, persistence of ETR is almost three times greater during periods of high M&A activity.

To corroborate their results, the researchers ran a simulation model which shows that 9.9 percent of all fund-years show significant targeting ability. This is nearly 10 times the number of fund-years one would expect merely due to chance. This signals that there is a systematic skill at play in explaining the fund performance. Having established that targeting ability exists, the study estimates the contribution of targeting ability to fund alpha. Alpha is a measure of the extra return on an investment compared with a suitable market index. It captures excess returns earned on an investment above the benchmark return and it is free of any compensation for risk.

The contribution of ETR to alpha is 54 basis points, which is the second highest contribution to alpha among all skill measures used as controls in the analysis. ETR is also reflected one-for-one into alpha. The researchers argue that investors can use past ETRs to identify funds that can generate alpha in the future. There could be alternative explanations as to why certain fund managers achieve higher returns. The study refutes all of them. These includes: fund managers tilt their portfolios towards stocks with a higher takeover probability and therefore are simply compensated for exposure to takeovers; fund managers overweight small stocks because they are more likely to become takeover targets; targeting ability is the by-product of a fund’s overall portfolio strategy and has nothing to do with predicting and investing in targets; fund managers have access to inside information on M&A deals through their connections with either investment bank employees or top management. The disproof of the latter claim is especially interesting in governance terms because it suggests that the skills of active managers work well within the limits set by good governance practices of intermediary organizations.

Targeting ability turns out to consist primarily in individual stock picking, as opposed to selecting whole industries with potential for future merger activity (only 12 percent of targeting ability is due to investing in industries that experience high M&A activity). Fund managers with targeting ability exhibit skills along three dimensions: they hold more targets, invest more capital in targets, and invest in targets that receive larger premia.

In conclusion, this study presents a novel measure of fund managers’ ability to identify stocks that become takeover targets. Their targeting ability results in mutual funds achieving returns in excess of their passive benchmarks. This ability persists over time and, therefore, past returns above and beyond benchmark can be used as predictors of future performance.

“Targeting Targets” Naveen D. Daniel (Drexel University), Daniel Dorn (Drexel University), David Pedersen (Rutgers University), 2022.

View the working paper on the Social Science Research Network