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«FOR 8 2011 ISSN: 1500-4066 MAY 2011 Discussion paper Merger negotiations with stock market feedback BY SANDRA BETTON, B. ESPEN ECKBO, REX THOMPSON, ...»

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INSTITUTT FOR FORETAKSØKONOMI

DEPARTMENT OF FINANCE AND MANAGEMENT SCIENCE

FOR 8 2011

ISSN: 1500-4066

MAY 2011

Discussion paper

Merger negotiations with stock

market feedback

BY

SANDRA BETTON, B. ESPEN ECKBO, REX THOMPSON, AND KARIN S. THORBURN

Merger negotiations with stock market feedback∗ Sandra Betton John Molson School of Business, Concordia University B. Espen Eckbo Tuck School of Business at Dartmouth Rex Thompson Cox School of Business, Southern Methodist University Karin S. Thorburn Norwegian School of Economics October 1, 2011 Abstract Pre-offer target stock price runups are traditionally viewed as reflecting rumor-induced market anticipation of the pending deal and thus irrelevant for offer price negotiations. Nevertheless, the empirical takeover literature suggests the existence of a costly feedback loop from target runups to offer premiums. We resolve this puzzle through a general pricing model under rational deal anticipation. The model, in which takeover rumors simultaneously affect takeover probabilities and conditional deal synergies, delivers important testable implications. Absent a costly feedback loop, (1) offer price markups should be highly nonlinear in target runups, and (2) bidder takeover gains should increase with target runups. Adding a costly feedback loop implies (3) the projection of markups on runups will be strictly positive. Our large-sample tests strongly support implications (1) and (2), but reject (3). We also show that while target share-block trades in the runup period fuel runups, such toehold purchases do not increase offer premiums. It appears that offer premiums are marked up by the (exogenous) market return over the runup period, however, this does not increase bidder takeover costs.

∗ We are grateful for the comments of Laurent Bach, Michael Lemmon, Pablo Moran and Annette Poulsen and, in particular, Eric de Bodt. We also thank seminar participants at the Norwegian School of Economics, University of Calgary, the 2011 Paris Spring Corporate Finance Conference, the 2011 UBC Summer Finance Conference, and the 2011 European Finance Association meetings. Contacts: sbett@jmsb.concordia.ca; b.espen.eckbo@dartmouth.edu;

rex@mail.cox.smu.edu; karin.thorburn@nhh.no.

1 Introduction There is growing interest in the existence of informational feedback loops in financial markets. In the context of corporate takeovers, a feedback loop means that secondary market price changes cause bidders to undertake corrective actions, such as offer price revisions and outright bid withdrawal.

While direct empirical evidence is sparse, some studies support the existence of feedback loops. For example, Luo (2005) and Kau, Linck, and Rubin (2008) find that negative stock returns around bid announcements increase the chance of subsequent bid withdrawal, as if bidders learn from the market price change.1 Bradley, Brav, Goldstein, and Jiang (2010) and Edmans, Goldstein, and Jiang (2011) find empirical links between general price changes of potential targets and subsequent takeover likelihood.

In this paper, we return to an interesting question first posed by Schwert (1996): do pre-offer target stock price runups cause the parties in merger negotiations to raise the offer price? The traditional view is that runups reflect rumor-induced market anticipation of the pending deal, and so runups ought to be irrelevant for offer price negotiations. Surprisingly, after studying the empirical relation between runups and offer price markups (offer premiums minus target runups), Schwert (1996) reaches the opposite conclusion.2 The notion that merger negotiations force bidders to increase the offer price with the target runup raises fundamental concerns about the efficiency of the takeover process. We address this puzzle through a general pricing model which shows the relation between runups and offer price markups consistent with rational market deal anticipation. This pricing structure turns out to be important as it clarifies earlier intuitive inferences about the existence of costly feedback loops, and it provides the basis for new structural empirical tests.

Our decision-making context is one where bidder and target management teams are about to finalize merger negotiations. There has been a recent runup in the target’s secondary market price, and the target management is demanding that the already planned offer premium be marked up In a similar vein, Giammarino, Heinkel, Li, and Hollifield (2004) examine the decision to abandon seasoned equity offerings (SEOs) following a negative market reaction to the initial SEO registration announcement. Bakke and Whithed (2010) develop econometric procedures for identifying general price movements of relevance for managerial investment decisions.

“The evidence...suggests that, all else equal, the [pre-bid target stock price] runup is an added cost to the bidder.” (Schwert, 1996, p.190). For discussions of optimal bid strategies in the presence of target runups, see e.g. Kyle and Vila (1991), Bagnoli and Lipman (1996), Ravid and Spiegel (1999) and Bris (2002).

to reflect this increase. If the runup reflects an increase in target value as a stand-alone entity (i.e.





the price increase is supported without a control change), adding the runup to the offer price is costless to the bidder and thus does not distort bidder incentives However, the runup may also reflect rumor-induced market anticipation of the pending deal.

In this case, revising the offer upward by the runup means literally paying twice for the target shares. There are several reasons why the risk of paying twice is substantial. First, empirical research has shown that takeover bids are frequently preceded by rumors and media speculations based on public information which may cause target runups (Mikkelson and Ruback, 1985; Jarrell and Poulsen, 1989). Second, runups driven by anonymous insider trades reflect private information already possessed by the negotiating parties and so also do not support a markup.3 Third, research shows that target runups on average reverse completely when all bids fail and the target remains independent (Bradley, Desai, and Kim, 1983; Betton, Eckbo, and Thorburn, 2009). This reversal would not take place if the sample target runups were reflecting increased stand-alone values. Last, but not least, bidders should be wary of target incentives to overstate the case for offer price markups regardless of the true source of the runup.

A rational response may be to assign some positive probability to both the deal anticipation and stand-alone scenarios and agree to some offer price markup. However, this is not the only possibility as optimal bidding when the market possibly knows something the bidder does not is complex. For example, bidders may initially refuse target demands to transfer the runup and leave it to potential competition to “prove” that target outside opportunities have in fact increased in value. The bidder would then abandon the takeover if the final premium becomes too high. Yet another possibility is for bidders with sufficiently high valuations to agree to a transfer of the runup notwithstanding the higher takeover cost. We are particularly interested in the latter bargaining outcome and refer to it as a “costly feedback loop” because the bidder ends up paying twice.

We begin by modeling the pricing relationship between target runups and subsequent offer price markups (offer premium minus the runup) when runups reflect rational deal anticipation.

A novel feature of this pricing model is that it permits takeover rumors—signals to the market about potentially synergistic takeover bids—to jointly increase bid probabilities and expected deal Meulbroek (1992) and Schwert (1996) find greater target runups in cases where the SEC subsequently alleges illegal insider trading.

values conditional on a bid. We show that this joint effect of the takeover signal implies a strictly nonlinear and non-monotonic relationship between runups and markups which has been previously overlooked.

The pricing structure delivers an important testable restriction of the costly feedback loop hypothesis. Under this hypothesis, the outcome of merger negotiations is to transfer runups to targets ex post. Rational bidders in this case adjust the minimum synergy threshold required to go through with a bid. Relative to a situation with no transfer of the runup, the greater bid threshold significantly increases both the surprise effect of observing a bid and the conditional expected bid value, causing runups and markups to move in the same direction for any observed bid. Thus, finding a negative relation between runups and markups constitutes a rejection of the costly feedback hypothesis.

Our empirical analysis uses 6,150 initial takeover bids for U.S. public targets from the period 1980 through 2008. We first demonstrate that the predicted nonlinear fit under rational deal anticipation is statistically superior to a linear—and even a nonlinear but monotonic—projection.

Likelihood ratio tests and tests exploiting implied residual serial correlations reject both linearity and monotonicity in the data. Empirical plots further show that the form of the nonlinearity is remarkably close to the theoretical form under deal anticipation.

We then show that the data rejects the predicted positive relation between runups and markups under the costly feedback hypothesis. The empirical relation is nonlinear and non-monotonic with a significantly negative average slope, consistent with rational deal anticipation and no transfer of the runup. This conclusion is robust to alternative definitions of markups and runups, and it holds whether or not we include a number of controls for bidder-, target- and deal-specific characteristics.

Just as rational deal anticipation constrains the relation between target runups and offer price markups, it also constrains the relation between target runups and bidder returns. The reason is obvious: stronger synergy signals in the runup period create greater runups and greater conditional expected takeover gains to both merger partners. Under deal anticipation, bidder takeover gains must therefore be increasing in the target runup. This implication receives strong empirical support.4 The statistically significant positive relation between bidder gains and target runups suggests (as the deal anticipation theory predicts) that the target runup is a proxy for total expected synergies in the takeover and not just for the portion accruing to target shareholders.

We provide two additional empirical discoveries which further support rational deal anticipation and reject the existence of a costly feedback loop. First, there does appear to exist a feedback loop from target runups—but one with no potential for distorting bid incentives. We find that offer prices are almost perfectly correlated with the market return over the runup period. Since the market return is exogenous to the merger synergies, the market-driven portion of the target runup presents the negotiating parties with prima facie evidence of a change in the target’s stand-alone value. As such it may be transferred to the target shareholders at no cost to the bidder, which appears to be the preferred bargaining outcome in practice.

Also, we present evidence on the effect of bidder open-market purchases of target shares during the runup period (which we refer to as “short-term toeholds”). Short-term toehold purchases are interesting in our context because they tend to fuel takeover rumors and target runups. We do find that runups are greater for takeovers with toehold acquisitions in the runup period. Nevertheless, toeholds reduce rather than increase offer premiums.5 We find no evidence that toeholds acquired during the runup period increase the cost of the takeover.

The rest of the paper is organized as follows. Section 2 lays out the dynamics of runups and markups as a function of the information arrival process surrounding takeover events, and it discusses predictions of the deal anticipation hypothesis. Section 3 performs our empirical analysis of the projections of markups on runups based on the theoretical structure from Section 2. Section 4 shifts the focus to the relationship between target runups and bidder takeover gains, developing both theory and tests. Section 5 concludes the paper.

2 Pricing implications of rational deal anticipation This section analyzes the information arrival process around takeovers, and how the information in principle affects offer prices and, possibly, feeds back into offer price corrections.6 As illustrated in Figure 1, the takeover process begins with the market receiving a rumor of a pending takeover bid, resulting in a runup VR of the target stock price. In our vernacular, VR is the market feedback to the negotiating parties prior to finalizing the offer price. Since the exact date of the rumor is The negative effect of toeholds on offer premiums suggests that toeholds improve the bidder’s bargaining position with the target (Bulow, Huang, and Klemperer, 1999; Betton, Eckbo, and Thorburn, 2009).

For additional analytical perspectives on information arrival processes around takeovers, see e.g. Malatesta and Thompson (1985), Lanen and Thompson (1988), and Eckbo, Maksimovic, and Williams (1990).

largely unobservable, VR is measured over a runup period. In our empirical analysis, we follow the convention in the literature and uses a two-month runup period, from day -42 through day -2, where day 0 is the date of the first public offer announcement. As shown in Figure 1, the average abnormal (market risk adjusted) target stock return over this runup period is approximately 8%, which is both statistically and economically significant.7 Moreover, we define the expected offer price markup as VP − VR, where VP denotes the expected final offer premium. In Figure 1, this is shown as the target revaluation over the three-day announcement period, from day -1 through day +1. The initial announcement does not resolve all uncertainty about the bid outcome: the initial bid may be followed by a competing offer or otherwise rejected by target shareholders. Thus, VP represents the expected final offer premium conditional on a bid having been made. The average three-day target announcement-induced abnormal stock return is approximately 21% in the full sample of takeovers.



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