Are Stock‐for‐Stock Acquirers of Unlisted Targets Really Less Overvalued?

• Date: 01 December 2013
• Published date: 01 December 2013
• DOI: http://doi.org/10.1111/fima.12022
• Author: Henock Louis

Are Stock-for-Stock Acquirers of

Unlisted Targets Really Less

Overvalued?

Henock Louis

Extant studies assume that targets’ private ownership mitigates acquirers’incentives and oppor-

tunities to finance acquisitions with inflated stocks. This view stems from the observation that,

although the average stock-for-stock acquirer’s merger announcement return is negative when

the target is listed, it is positive when the target is unlisted. Accordingly, extant studies often

suggest that announcements of stock-for-stock acquisitions of unlisted targets convey favorable

private information about the acquirers. However, an analysis of stock-for-stock acquirers’ stock

performance, abnormal accruals, net operating assets, and insider tradingsuggests the opposite.

Acquirers of unlisted targets aregenerally more overvalued than acquirers of listed targets.

Prior studies suggest that stock-for-stock acquirers are generally overvalued (Shleifer and

Vishny, 2003; Louis, 2004; Rhodes-Kropf and Viswanathan,2004; Rhodes-Kropf, Robinson, and

Viswanathan, 2005; Savor and Lu, 2009; Gao, 2010; Van Bekkum, Smit, and Pennings, 2011).

However, extant studies on the market reaction to acquisition announcements often assume that

targets’ privateownership mitigates acquirers’ incentives and opportunities to finance acquisitions

with inflated stocks. This view is supported by the observation that, although the average stock-

for-stock acquirer’s merger announcement abnormal return is negative when the target is publicly

owned, it is positive when the target is not publicly owned (Chang, 1998; Schultz and Zaman,

2001; Fuller, Netter, and Stegemoller, 2002; Louis, 2005; Faccio, McConnell, and Stolin, 2006).

The use of stock as the main currency in a transaction conveys an adverse signal about the

value of an acquirer’s stock (Leland and Pyle, 1977; Jensen and Ruback, 1983; DeAngelo,

DeAngelo, and Rice, 1984; Myers and Majluf, 1984; Travlos,1987; Chang, 1998). Chang (1998)

suggests that this adverse signal is mitigated when the target is privately owned. He maintains

that the willingness of the owners of a private target to “hold a large block of shares conveys

to the market favorable information about the bidding firm, resulting in a positive stock price

reaction to the merger proposal,” (p. 775). Accordingly, it is often presumed that stock-for-

stock acquirers of listed targets are generally overvalued, whereas stock-for-stock acquirers of

unlisted targets are not.1Moeller, Schlingemann, and Stulz (2005) find that large loss deals

are, overwhelmingly, acquisitions of publicly traded firms and that few of these deals involved

privately held targets. Theyconclude that their “results are consistent with the view that the large

loss deal firms were overvalued and that this overvaluation was corrected over time,” (p. 780).

Schultz and Zaman (2001) predict and document a positive market reaction to acquisitions by

Henock Louis is the KPMG Professor of Accounting at Pennsylvania State University in University Park,PA.

This paper benefits from very valuable comments by an anonymous referee, an anonymous associate editor, Raghu Rau

(Editor), Qingzhong Ma, Amy Sun, and Oktay Urcan.

1Throughout the paper, we refer to publicly traded targets as listed targets and non-publicly traded targets (privately

owned firms, assets, and subsidiaries) as unlisted targets.

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902 Financial Management rWinter 2013

Internet firms. They partially explain their finding by the notion that Internet f irms engage

primarily in the acquisition of privatelyheld f irms and “the new blockholders’ willingness to take

shares conveying positive private information to the market about the acquiring firm’s value.”

Slovin, Sushka, and Polonchek (2005) and Hege et al. (2009) also argue that the use of buyer

equity in an asset sale signals favorable information about the buyer’s value. Consistent with

the view that the use of stock to acquire unlisted targets conveys favorable private information

about the acquirer’s value, empirical studies on acquirer overvaluation are generally limited to

stock-for-stock acquisitions of publicly traded targets (Dong et al. 2006; Savor and Lu, 2009).

I argue that the managers of the average acquirer of an unlisted target do not necessarily have

favorable privateinfor mation about their firm. First, all else being equal, acquirers generally pay

substantially less for unlisted targets than for listed targets(Off icer,2007), which could explain the

favorable market reaction to announcements of acquisitions involving unlisted targets. Second, if

the average acquirer has incentives to finance an acquisition with overvalued stocks, there appear

to be few reasons why these incentiveswould totally disappear just because the target is privately

owned. Extant empirical evidence actuallyindicates that the positive effect of target private status

on stock-for-stock acquirers’ merger announcement returns holds even when the ownership stake

that the target receives in the bidder is small or no new blockholderis for med after the acquisition

(Chang, 1998; Faccio et al., 2006). This evidence leads Faccio et al. (2006) to conclude that the

fundamental factors that drive the differential announcement return for stock-for-stock acquirers

of privately owned targets remain elusive.

I further argue that targets’ unlisted status could actually increase acquirers’ incentives and

opportunities to finance acquisitions with inflated stocks. First, overvalued acquirers face serious

threats of very costly class-action lawsuits (Gong, Louis, and Sun, 2008a). Additionally, as

explained in the next section, these threats are less severe when a target is privately traded than

when it is publicly traded. Second, investors often use targets’ stock price reference points to

value proposed acquisitions. However, price reference points are essentially non-existent for

unlisted targets. Thus, as I explain in detail in the next section, at the announcement of an

acquisition involving an unlisted target, investors must focus their limited time and attention on

valuing the target, delaying the potential re-evaluation of the stand-alone acquirer. Third, if a

stock-for-stock acquirer is overpriced,market participants (managers, shareholders, and analysts)

who have vested interests in the target are more likely to uncover the overpricing around the

merger announcement than those who have no interest in the target.However, fewerinvestors and

institutions (including analysts) have interests in privately traded targets. Furthermore, contrary

to owners of publicly traded targets, owners of privately traded targets are generally prohibited

from trading in the shares of the merging firms around the merger announcement. Constraints

on investor trading activities (and investor inertia, in general) are likely to delay the correction of

acquirers’ pre-acquisition announcement overvaluation.

The evidence is consistent with my conjectures. I find that stock-for-stock acquirers experience

substantial market losses over the months after the acquisition announcement, irrespective of the

public status of the target. Moreover, the losses are larger for acquirers of unlisted targets than

for acquirers of listed targets. On average, acquirers of listed targets experience a market loss of

approximately 0.39% (0.35%) per month overthe 12 (24) months after the merger announcement.

For acquirers of unlisted targets, the average market loss more than doubles to approximately

0.94% (0.75%). These results suggest that, not only are stock-for-stock acquirers of unlisted

targets overvalued at the time of the acquisition announcements, but they are actually more

overvalued than stock-for-stock acquirers of publicly traded targets.

Acquirers of private targets may underperform after acquisition announcements because these

targets drive harder bargains than publicly traded targets. However, acquirers generally pay less