Do Capital Structure Adjustments by Takeover Targets Influence Acquisition Gains?

• DOI: http://doi.org/10.1111/fire.12134
• Published date: 01 May 2017
• Author: Tomas Jandik,Justin Lallemand
• Date: 01 May 2017

The Financial Review 52 (2017) 171–198

Do Capital Structure Adjustments

by Takeover Targets Influence

Acquisition Gains?

Tomas Jandik

University of Arkansas

Justin Lallemand∗

University of Denver

Abstract

We link debt issuances by target companies around takeover announcements to en-

hanced target bargaining power in negotiations with bidders over merger synergy gains in

completed takeovers. Announcements of debt issuances by targets—especially new bank

loans—are associated with more positive target equity returns relative to those made by

nontargets, particularly for debt issuances immediately surrounding the takeover announce-

ment. At least some of these gains to targets come at the expense of bidder shareholders,

as bidder equity abnormal returns at target debt issuance are negative. We further show

that targets issuing debt are primarily those with relatively low acquisition abnormal re-

turns, consistent with initially poor target bargaining power. Subsequent debt issuances by

targets increase the likelihood of positive adjustments to acquisition premiums offered by

acquirers.

∗Corresponding author: Daniels College of Business, University of Denver, 2101 S. University Blvd.,

Denver,CO 80210; Phone: (303) 871-4402; E-mail: justin.lallemand@du.edu.

We would like to thank an anonymous referee and Srinivasan Krishnamurthy (Editor) for their helpful

comments and suggestions that greatly improved the paper. We also thank Kathy Fogel, Paul Irvine,

Swami Kalpathy, Wayne Lee, Antonio Macias, Alexey Malakhov, Vassil Mihov, Sebastian Reinartz,

Craig Rennie, Thomas Shohfi, Tim Yeager, as well as seminar participants at Texas Christian University,

University of Arkansas, University of Denver, the 2015 Financial Management Association conference,

the 2013 Financial Management Association European conference, and the 2013 European Financial

Management Association conference. All remaining errors are our own.

C2017 The Eastern Finance Association 171

172 T. Jandik and J.Lallemand/ The FinancialReview 52 (2017) 171–198

Keywords: debt issuance, mergers and acquisition gains, bank debt

JEL Classifications: G32, G34

1. Introduction

Financial literature has linked capital structure decisions to merger and acqui-

sition (M&A) events. Higher debt levels maintained by potential takeover targets

are associated with lower takeover likelihood (Palepu, 1986; Billett, 1996; Billett

and Xue, 2007). For targets subjected to takeover attempts, Stulz (1988), Harris and

Raviv (1988) and Israel (1991) argue that by increasing debt, target managers can

retire shares held by investors with the lowest reservation values, while simultane-

ously increasing managerial equity stakes, and thus, managerial bargaining power.

Together, these theoretical models predict target company debt levels to increase in

anticipation of, and in response to, takeover attempts. Given that leverage increases

by targets enhance managerial bargaining power, these increases should result in

higher returns to target shareholders as improved bargaining power allows the target

to renegotiate for a greater share of merger synergy gains, coming at the expense

of bidder shareholders. Consequently, debt issues should be primarily undertaken by

targets with weak ex ante bargaining power.1

Although the theoretical models by Stulz (1988), Harris and Raviv (1988) and

Israel (1991) were developed a number of years ago, there exists only limited empir-

ical evidence of the influence of target company leverage on outcomes of completed

acquisition events. Billett and Ryngaert (1997) find that higher leverage levels are

associated with enhanced equity gains to targets. However, the authors link this ob-

servation to a purely mechanical premium leveraging effect, as opposed to enhanced

bargaining power,showing that for more highly levered targets, a set amount of acqui-

sition gains allocated to the target is divided over fewerremaining shares. We control

for this potential leveraging effect in our analyses, but instead focus on the role of

bargaining power shifts resulting from debt adjustments in merger negotiations.

Based on the analysis of 3,555 targets of successful takeover attempts from 1991

through 2010, we find results consistent with the redistribution of anticipated merger

1In addition to the concentration of equity ownership through recapitalization, targets may also benefit

from the signaling effect associated with new debt issuance. Corporations issuing debt have been found

to realize positive abnormal equity returns around the announcement of new debt (e.g., Mikkelson and

Partch, 1986), especially when new debt is provided by banks (James, 1987; Lummer and McConnell,

1989; Billett, Flannery and Garfinkel, 1995). Debt issuance announcements provide a positivesignal about

the quality of the issuer’s assets (Myers and Majluf, 1984) and about the willingness of external investors

to commit resources to the company. The signal of higher asset quality may enable targets to demand a

higher acquisition premium as financial literature generally associates higher relative target values with

larger target gains. Furthermore, the signaling of higher asset quality has the potential to attract additional

bidders. Both of these channels should be associated with greater takeover premiums accruing to the target.