Uncertainty or Misvaluation? New Evidence on Determinants of Merger Activity from the Banking Industry

Published date01 May 2016
Date01 May 2016
The Financial Review 51 (2016) 225–261
Uncertainty or Misvaluation? New
Evidence on Determinants of Merger
Activity from the Banking Industry
Robert Loveland
California State University, East Bay
Kevin Okoeguale
Saint Mary’s College of California
We use data from the past 30 years of takeover activity in the U.S. banking industry to
test competing neoclassical and misvaluation merger theories. Test results are consistent with
evidence in the literature that merger activity is significantlyrelated to both structural industry
change and stock price misvaluation. Our primary contribution is to show that changes in
misvaluation reflect a rise in industry-wide risk taking and that increases in risk originate from
changes in industry structure due to deregulation. A measure of bank risk taking subsumes the
power of stock price misvaluation to explain subsequent merger activity.
Keywords: mergers and acquisitions, deregulation, banking, idiosyncratic risk
JEL Classifications: G21, G34, G38
Corresponding author: Department of Accounting and Finance, College of Business and Economics,
California State University, East Bay, 25800 Carlos Bee Blvd., Hayward, CA 94542; Phone: (510) 885–
3130; Fax: (510) 885–7175; E-mail: robert.loveland@csueastbay.edu.
Wethank Scott Fung, Sinan Goktan, Jack He, Jim Linck, Harold Mulherin, Jeffrey Netter, Raluca Roman,
Drew Winters, seminar participants at California State University, East Bay, the University of Georgia,
and conference participants at the 2013 Financial Management Association meeting, 2013 Southern
Finance Association meeting and 2014 Southwestern Finance Association meeting for helpful comments,
suggestions and discussions. We are also grateful for the comments of two anonymousreferees.
C2016 The Eastern Finance Association 225
226 R. Loveland and K. Okoeguale/The Financial Review 51 (2016) 225–261
1. Introduction
Neoclassical explanations of corporate mergers and acquisitions (M&A) argue
that broad fundamental factors such as economic, regulatory, or technological shocks
drive industry mergeractivity, often in waves (Mitchell and Mulherin, 1996; Andrade,
Mitchell and Stafford, 2001; Harford, 2005). However, recent studies show that
periods of high stock market valuation are often positively correlated with increased
merger activity; the bull markets of the 1990s and mid 2000s being prime examples.
These papers employ both theory (Shleifer and Vishny, 2003) and empirical analysis
(Rhodes-Kropf, Robinson and Viswanathan, 2005) to support the behavioral and
asymmetric information explanations that managers use temporary misvaluation of
the firm’s stock to acquire assets or growth options. Because M&A are such a large
part of corporate capital expenditures, aggregate U.S. M&A deal value totaled over
$1.5 trillion in 2014 (Factset, 2015), determining the cause(s) of such a large turnover
in corporate control has implications for investors, corporate managers, and public
policy makers alike.
The aim of this study is to test the effects of both misvaluation and fundamental
shocks on takeover activity in a single industry. We use data from the past 30 years
of takeover activity in the U.S. banking industry to determine, empirically, whether
shocks to industry fundamentals or stock price misvaluation drive merger activity in
the industry. We also examine the specifics of how deregulation creates the forces
necessary to spur a merger wave in the industry.
The U.S. banking industry provides an excellent setting to contrast these two
broad hypotheses because the industry experienced several structural shocks via
deregulation and technological change over the sample period (Mitchell and Mul-
herin, 1996; Winston, 1998; Harford, 2005), and simultaneously benefited from
several bull markets (mid 1980s, 1990s, and mid 2000s) that provide fertile ground
for possible misvaluation. In addition, past multi-industry merger studies exclude
banking because its historically regulated nature is viewed to have muted natural
market responses, such as takeover activity, to industry change. The study of this
single industry provides an opportunity to test these theories with new data.
While the two contrasting explanations of M&A activity have generally been a
focal point of the literature relating to merger waves, more recent research builds on
the notion that industry-level M&A builds into a wave-like concentration of activity
only when other conditions are in place. Specifically, Harford (2005) shows that in
addition to the economic shocks that initiate the wave, capital liquidity is needed
to provide sufficiently low transaction costs to allow for large scale reallocation of
assets. Garfinkel and Hankins (2011) provide evidence that cash flow uncertainty,
typically created by industry shocks or increased competition, spurs companies to
vertically integrate to hedge against future cash flow volatility; actions which help
produce merger waves.
Although Rhodes-Kropf, Robinson and Viswanathan (2005) find significant
support for their merger misvaluation theory, when theytest their predictions against
R. Loveland and K. Okoeguale/The Financial Review 51 (2016) 225–261 227
neoclassical predictions they find support for both misvaluation and neoclassical
theory. They conclude that, despite the fact that most acquirers fall in the quintile
with the highest misvaluation, economic shocks could be the fundamental driver of
merger activity while misvaluation shapes how the shocks propagate through the
The U.S. banking industry is somewhat unusual in that it continues to this
day to be subject to significant government regulation, despite having undergone
extensive deregulatory change over the last 30 years. Importantly, deregulation did
not simply slow the economic decline of the industry as happened in some other
industries (Ovtchinnikov, 2013); it helped produce an increasingly profitable and
heterogeneous industry characterized by product innovation and diversification. This
resulted in higher levels of growth options and widening product profit margins.
Many studies examine the impact of deregulation and product diversification
on the risk/return profile of U.S. banks (Kwan, 1998; DeYoung and Roland, 2001;
among others). While some find that a growing reliance on revenue from noninterest
income sources (fee-based income, commissions, trading profits) produce a lower
expected risk-return relation, many such studies also find that the diversification
impacts on realized returns are short lived. Furthermore, the literature finds that some
noninterest income activities increase risk and lead to higher leverage (due to lower
capital requirements), thus producing a significant increase in earnings volatility
(DeYoung and Roland, 2001; Stiroh, 2004; Stiroh and Rumble, 2006).
Motivated by this evidence, we argue that deregulation ultimately caused an
increase in the level and dispersion of risk throughout the industry, which led to
increases in measures of industry stock misvaluation. Recent work demonstrates
that increases in firm-level cash flow volatility increase firm-level risk, as proxied
by idiosyncratic stock return volatility (Irvine and Pontiff, 2009). We lean on these
findings to support our argument that the increasingly heterogeneous and risky nature
of the banking industry made it increasingly difficult for investors to forecast future
revenues and profitability with certainty. Combined with industry consolidation that
suppressed acquirer’s market/book multiples, the increased uncertainty led to larger
discounts to estimates of long run value over the sample period.
We provide evidence in this paper to show that the Rhodes-Kropf, Robinson
and Viswanathan (2005) industry misvaluation proxy (a measure of aggregate stock
misvaluation at the industry level) increases significantly with increases in industry
cash flow volatility,a measure of uncertainty/risk. We also find that cash flow volatil-
ity increases with increases in both average industry revenue volatility and revenue
from fee-based products. Consistent with the findings in Rhodes-Kropf, Robinson and
Viswanathan (2005), we findthat banks with relatively low growth options buy banks
with higher growth options using high short-run firm-level valuations. Thus, while
structural industry change is responsible for impelling merger waves in the bank-
ing industry, the firm-level misvaluation measure of Rhodes-Kropf, Robinson and
Viswanathan (2005) is important in capturing who buyswhom: overvalued banks use
stock to buy relatively undervalued banks with higher growth options. However, test

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