Investor Recognition and Post‐Acquisition Performance of Acquirers

DOIhttp://doi.org/10.1111/fire.12166
Published date01 August 2018
Date01 August 2018
AuthorDi Cui
The Financial Review 53 (2018) 569–604
Investor Recognition and Post-Acquisition
Performance of Acquirers
Di Cui
Central University of Finance and Economics
Abstract
The literature has documented a negative relation between investor recognition and ex-
pected returns. This negativerelation is consistent with the prediction in Merton (1987, Journal
of Finance42, 483–510). This paper investigates whether the changes in investor recognition of
acquirers around the time of the acquisitions can explain the post-acquisition underperformance
of acquirer stocks. Using a large sample of U.S. acquisitions from 1980 to 2010, this paper
finds that investorrecognition, proxied by the number of institutional investors and the number
of common shareholders, increases significantly during acquisitions. Once the increases in in-
vestor recognition are controlled for, the “puzzling” long-run underperformances of acquirers
disappears.
Keywords: investor recognition, post-acquisition performance
JEL Classifications: G32, G34, G12
Corresponding author: Central University of Finance and Economics; Chinese Academy of Finance
and Development, South College Road 39, Beijing 100081, China; Phone: +86 13581692451; E-mail:
cuidi@cufe.edu.cn.
I thank the Editor, Richard Warr;two anonymous referees; Øyvind Norli; Richard Priestley; Bernard Du-
mas; Paul Ehling; Charlotte Østergaard; Ilan Cooper; Johann Reindl; Hamid Boustanifar; Danielle Zhang;
Dagfinn Rime; Øyvind Bøhren; Salvatore Miglietta; and Leon Bogdan Stacescu for helpful discussions.
I am also grateful for the seminar participants at BI Norwegian Business School and Nordic Finance
Network workshops for helpful comments.
C2018 The Eastern Finance Association 569
570 D. Cui/The Financial Review 53 (2018) 569–604
1. Introduction
It is well documented in the literature that acquirer stocks tend to underper-
form in the years following acquisitions (see, e.g., Asquith, 1983; Agrawal, Jaffe and
Mandelker, 1992; Mitchell and Stafford, 2000). Some earlier studies attribute the
post-acquisition underperformance of acquirer stocks to behavioral factors, arguing
that acquirers are overvalued during acquisitions and hence their prices reverse in
the long run (see, e.g., Shleifer and Vishny, 2003; Bouwman, Fuller and Nain, 2009;
Savor and Lu, 2009). More recent studies attempt to explain the post-acquisition
underperformance from the perspective of economic fundamentals. For example,
Bessembinder and Zhang (2013) and Mortal and Schill (2013) argue that certain risk-
related firm characteristics, such as investment, liquidity, and idiosyncratic volatility,
may account for the poor performance of acquirers following acquisitions. Nonethe-
less, there is still no consensus as to why acquirers underperform in the long run. This
paper proposes an alternative explanation to the post-acquisition underperformance
of acquirers based on Merton (1987). In particular, this paper examines whether the
abnormal post-acquisition returns can be explained by changes in investorrecognition
of acquiring firms around the time of the acquisitions.
Investorrecognition is a concept in Merton’s (1987) market segmentation theory.
It is defined as the fraction of investorsin the market who know about and hold a firm’s
securities. Deviating from the classical asset pricing theory, Merton (1987) assumes
that the information in the market is incomplete, in the sense that investors only
know a subset of securities in the market. Since investors only hold and form optimal
portfolios using securities they know about, in equilibrium, the demand for a security
is determined by the fraction of investors who knowabout the security. Consequently,
securities with low investorrecognition have lower prices and higher expected returns.
The literature documents empirical evidence supporting this relation between investor
recognition and cross-sectional expected returns (see, e.g., Bodnaruk and ¨
Ostberg,
2009; Fang and Peress, 2009; Lehavy and Sloan, 2009; Garcia and Norli, 2012).
Since acquisitions are associated with firm expansion, and are therefore likely
to experience stronger investor recognition, this paper hypothesizes that the lowpost-
acquisition acquirer returns documented in the literature are just a manifestation of
lower expected returns induced by broader investor recognition.
Using a broad U.S. sample of acquirer firms from the Thomson Reuters Security
Data Company (SDC) Platinum Mergers and Acquisitions database over the period
1981 to 2010, this paper examines the extent to which changes in investor recog-
nition may explain post-acquisition acquirer stock performance directly. First, we
show that there is a significant increase in investor recognition for acquirers around
the time of acquisition, and the increases in investor recognition for acquirers are
greater than in a matched sample of nonacquisition firms. We use the number of
institutional investors and the number of common shareholders, both of which are
standard measures in the literature, to measure investor recognition. The empirical
evidence shows that, on average, the number of institutional investors (number of
D. Cui/The Financial Review 53 (2018) 569–604 571
common shareholders) increases by 44.4% (53.8%) around the time of acquisitions,
and that the increase is permanent. This paper does not take a stand on the causal
relation between acquisition and increase in investor recognition. The announcement
of an acquisition may cause an expansion in investor recognition through broader
attention, media coverage, and/or analysts following. However, it is also possible that
increased investor recognition cause acquisitions. For example, a broader investor
base may trigger acquisitions through better access to capital. Since this paper fo-
cuses on the relation between the changes in investor recognition and post-acquisition
stock performance of acquirer firms, the causality between acquisition and increases
in investor recognition is of second order importance for this paper.
Second, we show that the changes in investor recognition can explain the post-
acquisition underperformance puzzle. We start by replicating the tests of the post-
acquisition underperformance literature, using both buy-and-hold abnormal return
(BHAR) and calendar-time approaches, and find that acquirers do underperform us-
ing both approaches. We then implement a refined BHAR approach proposed by
Bessembinder and Zhang (2013) to control for difference in firm characteristics.
When changes in investor recognition are taken into account, the return differences
across acquirers and the matched firms become economically or statistically in-
significant. We also sort the acquirer sample by the change in investor recognition
into quintiles and find that post-acquisition abnormal returns are decreasing with the
changes in investor recognition. In particular,a portfolio that is long in acquirers from
the bottom change in investor recognition quintile and short in acquirers from the top
change in investor recognition quintile yields a significantly positive buy-and-hold
return of approximately 24% during the 36 months following acquisitions. Overall,
the evidence we provide is consistent with the market segmentation theory.
Finally, we show that the effect of the change in investor recognition on post-
acquisition abnormal returns is not subsumed by extant alternative explanations.
According to Merton (1987), the negative investor recognition effect is stronger
when idiosyncratic risk is high. To examine this implication, we sort the acquirers
by both the change in investor recognition and idiosyncratic volatility, and consistent
with the market-segmentation theory, we observe that the impact of the change in
investor recognition increases with the level of idiosyncratic volatility. The investor
recognition explanation in this paper also helps understanding other cross-sectional
patterns of post-acquisition abnormal return documented in the literature. Loughran
and Vijh (1997) and Shleifer and Vishny (2003) argue that the underperformance
of acquirers is concentrated among stock-financed acquisitions because acquirers
only use stock when they believe they are overvalued. In contrast, we find that
cash-financed acquirers also experience low returns when the change in investor
recognition is large.
Rau and Vermaelen(1998) argue that managers and market evaluate the quality
of acquisitions based on the past performance of acquirers, and hence only low
book-to-market (BM) ratio (glamour) acquirers are overvalued, which as a result
underperform in the long run. However, we show that acquirers underperform in the

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