Management quality and acquisition performance: New evidence based on firm profitability

• Date: 01 July 2019
• Author: Wei Zhang,Hui Sono,Qingfeng Liu
• Published date: 01 July 2019
• DOI: http://doi.org/10.1002/jcaf.22388

BLIND PEER REVIEW

Management quality and acquisition performance:

New evidence based on firm profitability

Qingfeng Liu

1

| Hui Sono

1

| Wei Zhang

2

1

Department of Finance and Business Law,

College of Business, James Madison

University, Harrisonburg, Virginia

2

Department of Finance and Marketing,

College of Business, California State

University, Chico, California

Correspondence

Wei Zhang, Department of Finance and

Marketing, College of Business, California

State University, Chico, CA 95929.

Email: wzhang15@csuchico.edu

Abstract

Using corporate accounting profitability measures to proxy for management quality,

we report evidence that acquisitions made by higher quality acquirers create greater

shareholder value. More profitable acquirers earn better stock returns over the long

term, although no consistent relationship is found between announcement-period

abnormal returns and firm profitability. More profitable acquirers also preserve

shareholder value by reducing the likelihood of paying stock for acquisitions or over-

paying the targets. Overall, our results provide new support for the hypothesis that

better acquirers make better acquisitions. Our results also convey a clear message to

corporate accounting and financial executives, outside investors, and other profes-

sionals. When firms with poor accounting profitability make acquisitions, it is usu-

ally not good news.

KEYWORDS

acquisitions, firm profitability, inefficient market reactions, long-run returns, mergers

1|INTRODUCTION

Do better management teams create greater values for share-

holders in mergers and acquisitions (M&A)? Do firms with

better management quality tend to acquire more or even

overpay during M&A? The first question can be traced back

to Jensen and Ruback (1983) and has since been extensively

studied for decades. Though most of research argues for the

value creation of better management teams, the collective

evidence over time, however, is mixed, and even inconsis-

tent in some cases. Most of the results are based on either

Tobin's Q or its highly correlated market to book (M/B) ratio

as proxies for management quality or management perfor-

mance. Using Tobin's Q as a proxy, for example, Lang,

Stulz, and Walkling (1989) and Servaes (1991) find strong

results that high Q bidders create greater value for bidder

shareholders, supporting the proposition that better manage-

ment performance and better acquisition performance come

together. Using the M/Bratio as a proxy for mispricing and

based on a sample covering longer periods, Dong, Hir-

shleifer, Richardson, and Teoh (2006) report that bidders

with higher M/Bearn lower announcement returns and con-

clude that overvalued acquirers destroy shareholder value in

acquisitions. Management quality, as proxied by higher mar-

ket valuation (over book value), may be subject to market

overvaluation and the market will revalue the firm during

M&A events and price drops. Studies covering more recent

sample periods also report conflicting results.

1

Such incon-

sistent findings are not surprising because Tobin's Q and M/

Bratios are weak proxies for management quality. We

intend to reconcile the conflicting empirical results and fur-

ther explore whether firms with better management quality

acquire more often and whether they overpay in M&A.

In this article, we propose to use firm accounting profit-

ability to proxy for management quality. We argue that

We appreciate helpful discussions, comments, and suggestions from an

anonymous referee, Mehmet Akbulut, Yinfei Chen, Emily Huang,

Qingzhong Ma, Richard Ponarul, Norkeith Smith, Stephen Treanor, David

Whidbee, and seminar participants at California State University, Chico,

and the Southwestern Finance Association annual meeting at Albuquerque,

NM. All remaining errors are our own.

Received: 15 January 2019 Revised: 1 April 2019 Accepted: 3 April 2019

DOI: 10.1002/jcaf.22388

44 © 2019 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jcaf J Corp Acct Fin. 2019;30:44–63.

previous proxies using Tobin's Q or Market-to-Book ratio to

measure management quality contain a market valuation fac-

tor which is subject to market mispricing. Any market

misvaluation will complicate the inference of management

quality on acquirer returns, thus substantially reducing the

empirical power in testing the management quality hypothe-

sis, and contribute to the inconsistent empirical findings in

previous studies. A measure for management quality does

not have to be market value related, however. If it is market

value related, it is valid only if the market is efficient.

To reexamine the role of management quality in acquisi-

tion performance, we adopt new proxies for management

quality that are free from market prices. The proxies we

choose are based on firm profitability. We argue that the

profitability, free from market misevaluation noise, evaluates

the current performance of management and would better

signal their future performance. First of all, in the seminal

paper, Brainard and Tobin (1968) point out that the impact

of Tobin's Q on investment is equivalent to that of the real

returns on physical investment, or profitability.

2

Similarly,

Lang et al. (1989) justify their use of Tobin's Q as a proxy

for management performance because Tobin's Q is “an

increasing function of the quality of a firm's current and

anticipated projects under existing management.”Besides,

the increasing trend of executive compensation contingent

on accounting-based performance (see Li & Wang, 2016)

provides further justification. Earlier studies have used prof-

itability related measures to proxy for management quality

to examine value creation at M&A announcement period.

Morck, Shleifer, and Vishny (1990) and Masulis et al.

(2007) use operating income growth to proxy for manage-

ment quality to explain acquirer announcement-period

abnormal returns.

3

Because the measurement of firm profitability can be

noisy and subject to manipulation prior to acquisitions, we

adopt three proxies: gross, operating, and net profitability.

Novy-Marx (2013) shows that gross profitability has

roughly the same power as B/M ratio predicting cross-

sectional returns. He argues that gross profits-to-assets con-

tributes economically significant information above that of

valuations. Ball, Gerakos, Linnainmaa, and Nikolaev (2015)

show that operating profits-to-assets presents an even stron-

ger link with expected cross-sectional returns. As Novy-

Marx (2013) points out, in comparison to operating and net

profitability, gross profitability is least likely to be subject to

contamination. Compared to Tobin's Q or M/Bratio, the

three profitability measures have the common advantage in

that they are not directly affected by market misvaluation.

In our empirical analyses, we examine not only the

announcement-period abnormal returns, but also the long-

run returns following acquisitions. Many existing studies

rely on announcement-period abnormal returns as a proxy

for acquisition performance (e.g., Masulis et al., 2007;

Morck et al., 1990). The choice of the announcement period

is legitimate under the assumption that investors rationally

react to M&A announcements. Several recent studies cast

doubt on this assumption, however, and show that the

announcement-period returns can be noisy and do not per-

fectly reflect the value implications of the acquisitions

(e.g., Danbolt et al., 2015; Ma et al., 2019). Thus, we exam-

ine both the abnormal returns at the announcement period

and the acquirer abnormal returns over the longer periods

following the announcements. We expect that in a longer

period, market reactions shall settle down and firms show

more consistent results in their management performance.

For a comprehensive sample of M&A deals announced

in the 1981–2014 period, we report the following findings

based on three proxies for firm profitability: gross, operat-

ing, and net profitability. First, none of the profitability mea-

sures appear to affect significantly the market responses at

the announcement period. Second, the stock returns of

acquirers with higher gross profitability outperform less

profitable ones over the horizon of 1–3 years. Third, more

profitable acquirers are more likely to pay cash and less

likely to pay stock for the acquisitions. Finally, there is no

strong evidence that acquirers with higher profitability pay

higher premiums for publicly traded targets. The overall

findings are consistent with the joint hypothesis that acquisi-

tions are partly motivated by improving efficiency, that the

market reaction to the M&A announcements is not efficient,

and that the efficiency improvement is only reflected in the

market price over the longer term.

This article adds to the M&A literature by filling a

reemerging gap. Specifically, we retest the important propo-

sition regarding the role of management quality in creating

shareholder value in M&A using profitability measures. This

proposition has been the central argument of the market for

corporate control (see Jensen & Ruback, 1983). Because the

existing empirical tests of this proposition rely on market

valuation, the empirical findings cannot distinguish between

the management quality and misvaluation hypotheses, leav-

ing questionable the validity of the management quality the-

ory. To overcome this challenge, we propose firm

profitability as proxies for management quality.

4

Our find-

ings suggest that firms with better profitability create more

values for shareholders in acquisitions, but the overvalued

acquirers destroy shareholder value. Our results also high-

light the importance of accounting, in that different account-

ing profitability measures carry different information, with

the cleanest profitability measure (gross profitability) gener-

ating the clearest results.

It is worth noting that firm operating performance as rep-

resented by the GP/A, OP/A, and NP/A measures can reflect

many different firm attributes. For example, firms may have

LIU ET AL.45