How Much Is Too Much: Are Merger Premiums Too High?

European Financial Management, Vol. 14, No. 2, 2008, 268–287doi: 10.1111/j.1468-036X.2007.00404.x

How Much Is Too Much: Are MergerPremiums Too High?

Antonios AntoniouDurham Business School, University of Durham, Durham, DH1 3LB, UKE-mail: [email protected]

Philippe ArbourLloyds TSB Corporate Markets, 10 Gresham Street, London, EC2V 7AE, UKE-mail: [email protected]

Huainan ZhaoFaculty of Finance, Cass Business School, London, EC1Y 8TZ, UKE-mail: [email protected]

Abstract

Is it too much to pay target firm shareholders a 50% premium on top of marketprice? Or is it too much to pay a 100% premium when pursuing mergers andacquisitions? How much is too much? In this paper, we examine how the extentof merger premiums paid impacts both the long-run and announcement periodstock returns of acquiring firms. We find no evidence that acquirers paying highpremiums underperform those paying relatively low premiums in three yearsfollowing mergers, and the result is robust after controlling for a variety of firmand deal characteristics. Short term cumulative abnormal returns are moreoverpositively correlated to the level of the premium paid by acquirers. Our evidencetherefore suggests that high merger premiums paid are unlikely to be responsiblefor acquirers’ long-run post merger underperformance.

Keywords: mergers and acquisitions, corporate takeovers, merger premiums,abnormal returns, event study

JEL classification: G14, G34

Evidence suggests that the majority of acquisitions do not benefit shareholders inthe long term. Valuations and premiums tend to be excessively high and targetsimpossible to achieve.

Financial Times, 2004We would like to thank George Alexandridis, John Doukas (the editor), Phil Holmes, HerbertLam, Fengliang Liu, Krishna Paudyal, Dimitris Petmezas, seminar participants at DurhamBusiness School, Renmin University of China, and especially an anonymous referee forhelpful comments on previous drafts of this paper. We would also like to thank Yifan Chenand Fangming Xu for their excellent research assistance. (Corresponding author: HuainanZhao)

C© 2007 The AuthorsJournal compilation C© 2007 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA02148, USA.

Are Merger Premiums Too High? 269

1. Introduction

Research on mergers and acquisitions (M&A) suggests acquirers do not normally benefitfrom acquisitions. Target firms, however, tend to benefit generously from M&A due tohigh merger premiums paid by acquirers on average; this is typically illustrated by largepositive abnormal returns earned in the few days surrounding merger announcements.The announcement period wealth effect on acquiring firms, on the other hand, is lessclear. On average, acquirers break even in the few days around merger announcements.In the long-run, research has shown that acquiring firms (i.e., the combined acquirerand target) earn a statistically significant negative abnormal return up to five yearsfollowing mergers, widely known as the post merger underperformance puzzle.1 Takenat face value, these findings cast a doubt on the ability of bidding firm management tomake value creating decisions on behalf of their shareholders.

There is a growing belief that the poor long-run performance of acquirers may beattributable to overpayments in mergers. Could it be that merger premiums are toohigh in relation to the realisable economic gains from merging? As Schwert (2003)puts it: ‘. . . One interpretation of this evidence (post merger underperformance) is thatbidders overpay and that it takes the market some time to gradually learn about thismistake’. Thus, overpaying (i.e., paying an excessive merger premium) is perhaps theprime suspect behind the long-run underperformance puzzle.

From a bidding firm perspective, the success of acquisitions must be measured overa specified time frame with the benefits from merging (i.e., synergies, increases inproductivity, incremental cash flows, margins, reductions in the cost of capital etc.,)compared to the initial cost of the investment.2 Indeed, a simple net present value (NPV)framework can shed light on the desirability of a given M&A transaction. If potentialgains from merging are real and managers do not overpay, acquisitions should yield apositive NPV and should therefore create value on behalf of acquiring firm shareholders.But Roll’s (1986) hubris hypothesis predicts that, if present, hubris infected managerswill win the auction process. Ex post observable samples of M&As will therefore bebiased towards value destroying deals. Moreover, since potential target firm stock pricesare likely to carry a takeover premium during merger waves, it is highly probable thatthe market value of the target will exceed its fundamental value during such waves.Further, a high premium may be offered on top of what may already be an overvaluedtarget stock price. It therefore follows that, holding synergies constant, the higher thepremium paid, the greater the probability of engaging in a value-destroying M&A deal.

In a recent study, Moeller et al. (2004) find that the average (median) premium paidfor US public acquisitions with announcement dates between 1980 and 2001 was 68%

1 For US empirical evidence, see, for example, Asquith (1983), Malatesta (1983), Jensenand Ruback (1983), Magenheim and Mueller (1988), Agrawal, Jaffe, and Mandelker (1992),Loderer and Martin (1992), Anderson and Mandelker (1993), Loughran and Vijh (1997),Rau and Vermaelen (1998), Agrawal and Jaffe (2000), and Megginson et al. (2004). ForUK evidence, see, for example, Firth (1979), Franks and Harris (1989), Limmick (1991),Kennedy and Limmick (1996), and Gregory (1997). There are, however, other studies(e.g., Bradley and Jarrell (1988), and Franks et al. (1991)) that do not find significantunderperformance in the three years following the merger.2 Bruner (2004) argues that business practitioners should be very careful when assessing thebenefits of an acquisition. He argues that the cost of capital should serve as a benchmarkfor assessing the performance of M&A and cautions potential acquirers on overpaying inM&A deals pursued.

C© 2007 The AuthorsJournal compilation C© 2007 Blackwell Publishing Ltd

270 A. Antoniou, P. Arbour and H. Zhao

(61%) for large firms and 62% (52%) for small firms. In other words, average premiumsare so high that they implicitly require massive growth targets and cost savings tomaterialise for M&A transactions to be justified. In this paper, we therefore examinewhether high merger premiums paid are a key driver of the well documented long-run underperformance of acquiring firms. Our a priori expectation is that overpayingincreases the likelihood of a value destroying deal, which should lead to inferior post-merger stock performance (relative to firms paying lower premiums).

To test empirically this overpayment hypothesis, we have to deal with long termabnormal returns measurement. As referenced above, many previous works highlightthe existence of negative long term abnormal returns to bidders. But is this underperfor-mance anomaly real? Many researchers have argued that it might not be. It is widely ac-cepted that measuring long-run abnormal returns is treacherous.3 Fama (1998) dismissesmost reported long-run anomalies as chance occurrences and shows that these so-calledanomalies simply ‘disappear’ with a reasonable change in technique. Therefore, it isnot clear whether these so-called anomalies pose a serious challenge to the efficientmarket hypothesis. In this study, we follow Fama (1998) and Mitchell and Stafford(2000) by employing calendar time portfolio regression (CTPR) to control for the cross-sectional dependence of sample observations arising from clustering in mergers andoverlapping returns shared by frequent bidders. In testing our hypothesis, however, wemust stress that we do not focus on the long-run abnormal performance of acquirers perse. Instead, we focus our analysis on the differences of long-run abnormal performancebetween two key sub-portfolios, namely the High and Low premium paying acquirer sub-portfolios. Though we generally agree with the numerous critics of measuring long-runabnormal returns, we believe that the probability of measurement biases systematicallyaffecting our two sub-portfolios in a different way seems a priori low.

Based on a sample of 396 successful UK public mergers between 1985 and 2004,we examine whether sub-portfolios consisting of the highest premium paying acquirersearn significantly lower returns than sub-portfolios consisting of lower premium payingacquirers in the 3 years following mergers. We find that, for the whole sample, returndifferentials between High and Low premium sub-portfolios are small and statisticallyinsignificant. We then control for a variety of firm and deal characteristics, namelymethod of payment, book-to-market ratio, relative size, and corporate diversificationand again we find that return differentials between High and Low sub-portfolios arestatistically insignificant. Our research is therefore significant in that it demonstratesthat merger premiums are not to blame for bidders’ long-run underperformance andthat, in the same spirit of Berkovitch and Narayanan (1993) and Eccles et al. (1999),it is quite possible that merger premiums may actually proxy for the synergy reservesbetween a bidder and its target. To test this latter hypothesis, we investigate whetherannouncement period abnormal returns concur with our long-run analysis. In 3 and5 days surrounding merger announcements, we find that acquirers paying high premiumsoutperform their low premium paying counterparts. At the combination level (target andacquirer), high premium paying bidders significantly outperform low premium ones. Theshort-run evidence is therefore consistent with our long-run results and indicates thathigh premiums may better proxy for deal synergies than overpayments. That is, our short-run evidence indicates that the merger premium paid for individual deals is a significantindicator of deal synergies in the eyes of markets. It appears that market estimates of

3 See for instance, Barber and Lyon (1997), Kothari and Warner (1997), Lyon, Barber andTsai (1999).



deal synergies are permanently capitalised at the merger announcement as we do notsubsequently observe long term systematic return differentials between acquiring firmspaying the highest premiums compared to those paying the lowest premiums.

The rest of the paper is organised as follows. Section 2 describes the data. Section 3introduces the methodology used in our empirical study. Section 4 reports and discussesthe empirical findings. Section 5 concludes the paper.

2. Data

We examine a sample of successful UK public mergers occurring between 1985 and2004. Our sample is drawn from the Securities Data Corporation (SDC) merger databaseusing the following criteria: (1) All bidders are UK public firms, and target firms areUK or international public firms; (2) The deal value of the merger is over one millionUS dollars.4 (3) Financial and utilities firms are excluded; (4) Bidders acquire at least50% of the targets, thereby implying control. 601 firms meet above general criteria. Forthe purpose of this study, we require that the one-month merger premium5 data is eitherdirectly available from the SDC or can be calculated from the information provided bythe SDC. This reduces the sample size to 427 firms. We then collect acquiring firms’monthly stock prices, size (market value), and book-to-market ratios from ThomsonFinancial Datastream. We also obtain the information on method of payment from theSDC. After applying our data filter, we obtain 396 bidders from the period 1985–2004for the short-run analysis and 365 acquirers from the period 1985–2001 for the long-runinvestigation.

Table 1 presents descriptive statistics for the sample. Column 2 in the table showsthe number of mergers that occurred in each of the sample years. It is evident that theUK M&A market experienced a merger boom in the late 1980s, slowed down between1990 and 1996 and experienced another roar in the remaining period up until 2001.Our sample is therefore representative of transactions which occurred during the UKmerger waves of the late 1980s and 1990s. Column 3 provides the average and medianone-month merger premiums paid for sample targets. Average premiums for each yearwithin the sample period range from 35% to 110%. Columns 4, 5, and 6 show theproportion deals financed with cash, stock or mixed payments (neither pure cash norpure stock) for a given calendar year. For the whole sample, over half (52%) of all dealswere financed with cash, while stock for stock and mixed payments are rather equallypopular with a 22% and 26% frequency respectively.

4 We follow Fuller et al. (2002), Moeller et al. (2004, 2005), and Moeller and Schlingemann(2005) and employ a one million dollar cut-off to avoid results being driven by very smalldeals. In fact, although we apply the one million dollar cut-off point, 90% of our samplefirms have a deal value above 10 million dollars, 55% above 50 million dollars, and 42%above 100 million dollars.5 Evidence has shown that the most significant market value changes for target firms occurat the merger announcement date or on the day before the announcement. Thus the useof one-month merger premiums should capture the difference between the offer price andthe target’s pre-merger price. See, for example, Dodd (1980), Asquith (1983), Dennis andMcConnell (1986), Huang and Walkling (1987), and Bradley and Jarrell (1988). The one-month merger premium equals the difference between the initial bid price and the targetmarket price four weeks prior to the initial merger announcement divided by the same targetprice four weeks prior to the announcement.



Table 1

Descriptive statistics for mergers announced and completed between 1985–2004

The sample consists of 396 U.K. public bidders that have acquired one or more public target firms

within a three-year period and with a deal value of one million dollars or more. There are three methods

of payment employed in mergers: pure cash, pure stock, and mixed. The mixed payment subset includes

all mergers in which the method of payment is neither pure cash nor pure stock. The merger premium

is defined as the four-week pre-announcement premium. It equals the difference between the initial

bid price and the target market price four weeks prior to the initial merger announcement divided by

the same target price four weeks prior to the announcement. Table 1 reports the number of mergers,

the mean and median merger premium, and the proportion of transactions for each method of payment

in each calendar year. The median merger premiums are shown in parentheses.

Premium Cash Stock MixedYear No. of Firms (%) (%) (%) (%)

1985 2 110 (110) 100 0 01986 2 70 (70) 0 100 01987 28 36 (42) 46 32 221988 32 48 (43) 88 9 31989 27 44 (41) 63 19 181990 18 45 (51) 61 22 171991 12 35 (41) 42 25 331992 5 64 (32) 0 20 801993 5 71 (43) 60 0 401994 10 39 (41) 50 30 201995 17 36 (38) 41 18 411996 12 39 (34) 33 33 341997 26 42 (44) 46 31 231998 41 43 (38) 54 19 271999 57 51 (40) 45 16 392000 41 50 (46) 36 37 272001 30 37 (35) 64 13 232002 11 41 (31) 64 9 272003 15 41 (37) 40 27 332004 5 42 (29) 40 40 20

Total 396 45 (40) 52 22 26

Table 2 reports deal and firm characteristics for our sample. Descriptive statistics areprovided for the whole sample and for three sub-samples, namely, Low (30%), Medium(40%), and High (30%) premium paying acquirers. The average one-month mergerpremium for the full sample is 45%; 10%, 42%, and 89% for the Low, Medium andHigh premium sub-samples respectively. Mean and median premiums are comparable.Thus, High premium paying acquirers paid a mean (median) merger premium that wasover 9 (8) times as large as that paid by the Low acquirers. In terms of other firmand deal characteristics, the average (median) deal value for the full sample is £398(£69) million; although the mean deal value of High acquirers (£501 million) is largerthan that of Low acquirers (£356 million), High-Low differentials are insignificant. Themean (median) firm size of acquirers (i.e., market value of equity) for the full sample is£1,685 (£390) million and interestingly, the High sub-sample has a lower average/mediansize (£1,464m/£343m) than the Low one (£1,633m/£390m), but the High-Low



Table 2

Summary Statistics: Sorted by Merger Premium


within a three-year period and with a deal value of one million dollars or more. The merger premium


bid price and the target market price four weeks before the initial merger announcement divided by

the same target price four weeks prior to the announcement. Acquiring firms are ranked by merger

premiums and partitioned into three portfolios according to their ranking. Low premium portfolio

comprises the lowest 30% premium paying firms. Medium premium portfolio comprises the middle

40% firms. High premium portfolio comprises the highest 30% firms. The deal value (£million) is

the total value of consideration paid by the acquirer, excluding fees and expenses. Size is the market

capitalization of acquirers. Relative size is the deal value divided by the size of the acquirer. Book-to-

market is acquirers’ book value of equity divided by the market capitalization. Days to completion are

the number of calendar days between the announcement and effective days. Acquirer total liabilities/size

is the ratio of acquirers’ total liabilities to acquirers’ total market value of equity at merger completion.

Target EPS 3-year growth rate is the average three-year earnings per share growth rate prior to the

merger. Cash payment refers to deals paid for using 100% cash, while stock payment refers to deals

paid for using 100% stock. The table reports both mean and median values. The median values are

shown in parentheses. For High-Low, the test statistics used are both the conventional parametric t-test

and the nonparametric wilcoxon test. The parametric t-values are reported in square brackets. The

nonparametric p-values are reported next to the t-statistics in parentheses.

Low Medium High

Premium Premium PremiumCharacteristics All Firms (30%) (40%) (30%) High-Low

Premium (%) 45 10 42 89 79(40) (11) (40) (78)

Deal Value (£Mil) 398 356 337 501 165(69) (45) (96) (65) [0.51] (0.16)

Size (£Mil) 1685 1633 1889 1464 −168(390) (390) (385) (343) [−0.37](0.86)

Relative Size 0.54 0.51 0.58 0.50 −0.01(0.22) (0.22) (0.23) (0.20) [−0.15] (0.82)

Book-to-Market 0.52 0.51 0.56 0.48 −0.03(0.42) (0.47) (0.41) (0.41) [−0.41] (0.55)

Days to Completion 84 88 82 84 −4(69) (72) (64) (67) [−0.46] (0.73)

Acquirer Total 0.72 0.59 0.79 0.74 0.15Liabilities/Size (0.48) (0.37) (0.52) (0.48) [0.79] (0.49)

Target EPS 3-Year 20 28 17 17 −11Growth Rate (%) (11) (8) (16) (9) [−0.79] (0.56)

Cash Payment (%) 52 52 51 52 0Stock Payment (%) 22 27 19 22 −5Friendly Deals (%) 91 90 94 89 −1Same Industry (%) 47 49 43 51 2

differential is not significant. This finding at least suggests that, for our sample, acquirersize may not necessarily be positively correlated with the extent of the merger premiumpaid. The mean (median) relative size (defined as deal value divided by the acquirer’smarket value of equity) for the full sample is 0.54 (0.22). The average relative size



for High premium acquirers is 0.50, which is similar with 0.51 for Low acquirers.Sample acquirers thus pursue meaningful acquisitions in terms of relative size. Themean (median) book-to-market ratio of acquirers is 0.52 (0.42) for the full sample; Highand Low sub-sample ratios are comparable. For the full sample, acquirers take 84 dayson average to complete a merger; a result which is constant between High and Low sub-samples. Next, we observe that High acquirers command a higher mean (median) ratio oftotal liabilities to size at merger completion 0.74 (0.48) compared to Low acquirers 0.59(0.37), though mean differentials are insignificant. The information on target firm EPSgrowth rate shows that High acquirers tend to pursue targets with a lower mean 3-yearpre-merger EPS growth rate (17%), which is insignificantly different from the growthrate of targets (28%) pursued by Low acquirers. For method of payment, we observethat High and Low acquirers are equally as likely to pay for acquisitions using cash.The proportion of stock financed deals is also constant amongst sub-samples. We alsoobserve that most deals are friendly and the proportion is stable amongst sub-samples.Finally, more than half the deals in the full sample provide corporate diversification, andthe proportion is comparable in High and Low sub-samples. In short, Table 2 illustratesthat firm and deal characteristics for High and Low sub-samples are not systematicallydivergent.

3. Methodology

3.1. Long-run method

Following Fama (1998), Mitchell and Stafford (2000), we employ the Calendar-TimePortfolio Regression (CTPR) approach to control for the cross-sectional dependenceproblem arising from industrial clustering in mergers and overlapping returns sharedby frequent bidders. Although we cannot claim to be able to resolve all long-run stockreturn measurement biases by using the CTPR approach, we have little reason to believethat these potential biases will systematically affect sub-samples (the High and Lowpremium paying sub-portfolios in our case) in different ways.

In each calendar month, a portfolio is formed consisting of all acquirers that havecompleted a merger in the past 36 months. We rebalance our calendar portfolios monthlyto include acquirers that have just completed an event and to drop those acquirers thathave fulfilled 36 months in the calendar portfolio. Based on the calendar portfolio return,we then estimate the Fama-French three-factor model6 as follows:7

Rpt − R f t = ai + βi (Rmt − R f t ) + si SMBt + hi HMLt + εi t (1)

where Rpt is the average monthly return of the calendar portfolio; R f t is the monthlyrisk free return; Rmt is the monthly return of the value-weighted market index; SMBt thevalue-weighted return on small firms minus the value-weighted returns on large firms,

6 We are grateful to Professor Krishna Paudyal for providing us with the UK three factorswhich are compiled according to Fama and French (1996 ) using data available from ThomsonFinancial Datastream.7 We estimated both equal- and value-weighted calendar portfolio returns, the value-weightedresults are qualitatively similar to the equal-weighted results. In the interest of brevity, wereport only the equal-weighted results in the paper.



and HMLt the value-weighted return on high book-to-market firms minus the value-weighted return on low book-to-market firms. We note that the intercept (alpha) in thisregression is the mean monthly abnormal return for each portfolio over the estimationperiod.

To test whether the extent of the merger premium paid is a determinant of the long-run post-merger stock performance of acquiring firms, we rank sample firms by mergerpremiums paid and allocate firms to one of three calendar portfolios (Low, Medium, andHigh) based on their rankings. The Low premium portfolio comprises the lowest 30%premium paying firms, the Medium portfolio comprises middle 40% premium firmsand the High portfolio comprises the highest 30% premium firms. We employ zeroinvestment portfolio regressions to assess whether return differentials between pairedsamples (High and Low) are significant.

Rhight − Rlowt = ap + βp(Rmt − R f t ) + sp SMBt + h p HMLt + ept (2)

Where Rhight is the return on the High premium portfolio and Rlowt is the return on theLow premium portfolio. The intercept (alpha) in equation (2) is the return differentialbetween High and Low portfolios. A significant alpha implies a statistically significantHigh-Low return differential.

3.2. Short-run method

We follow Fuller et al. (2002) and Dong et al. (2006) standard event study methodologyto calculate CARs for the three-day (−1, +1) and five-day (−2, +2) event windowssurrounding merger announcements. We calculate abnormal return based on market-adjusted returns:

ARi = Ri − Rm (3)

where Ri is the return on event firm i and Rm is the value-weighted market indexreturn.

4. Empirical Results

4.1. Do high premium paying acquirers under perform following mergers?The long-run evidence

Applying the overpayment hypothesis to M&A, acquirers that overpay for targets shouldexperience a delayed downward price correction in the post merger period, especially ifmarkets overreact to the initial merger announcement. As information becomes availableconfirming that the combined firm cannot meet pre-established (i.e., initially forecasted)financial targets, investors will retroactively reassess the price paid for the target (mergerpremium), thereby leading to a subsequent downward revision in stock price. There aredifferent reasons for overpayments in mergers. The conflict of interests hypothesis statesthat acquiring firm management will engage in self-serving activities at the expense ofshareholders (Jensen and Meckling, 1976; Fama, 1980; Fama and Jensen, 1983; Jensen,1986). If managers truly set out to build empires for instance, the latter theory thuspredicts that acquiring firm management will give little consideration to price (and payhigh premiums) when pursuing acquisitions. On the other hand, the hubris hypothesisstates that acquiring firm managers might be over optimistic about their past performance



and may overestimate the economic gains (i.e., synergies) necessary to recoup highpremiums paid (Roll, 1986). In other words, managers may be naı̈ve as to how muchwork is involved in creating economic value through acquisitions. We therefore proposethat, if high premiums are indeed responsible for the long-run underperformance ofacquirers, we would expect to see high premium paying acquirer portfolios underperformlow premium paying acquirer portfolios in the three years following mergers.

To explore whether high premiums paid lead to inferior post-merger stock returns,we first examine the full sample and then proceed to examine the sub-samples sortedby the extent of premiums paid (i.e., Low 30%, Median 40%, and High 30%), andthen test for the statistical significance of return differentials between the High andLow premium portfolios as measured by the alphas in the zero-investment portfolioregressions.

It is clearly seen in Table 3 that, for the full sample, acquiring firms (combined biddersand targets) exhibit statistically significant (at the 1% level) negative monthly averageabnormal returns ranging from −1.24% to −1.28% in 1 to 3 years following mergers.This result is not favourable to the desirability of M&A in general but is nonethelessconsistent with the majority of the evidence on long-run post merger stock performance.Could overpaying be behind this negative performance? If excessive premiums arethe principal reason for acquirers’ long-run wealth loss, then it follows that the Highpremium portfolio (with a mean premium 9 times as high as the Low portfolio) shouldat least under perform the Low portfolio. To find an answer to this question, we turnour attention to the sub-samples (Low, Medium and High) sorted by merger premiums.Once again, all three sub-portfolios earn a significantly negative return in the threeyears following mergers. However, the High-Low return differentials are small andstatistically insignificant; for example, the 3-year High-Low return differential is −0.5%with a t-statistic of −1.31. Hence, for our sample of UK firms, we cannot state thathigh premium paying acquirers under perform low premium acquirers in the three yearsfollowing mergers. Our initial analysis therefore suggests that high merger premiumsare not drivers of the observed long-run post merger underperformance of acquiringfirms.

4.2. Robustness check

We now control for a variety of known firm and deal characteristics namely the methodof payment, book-to-market ratio, relative size, and corporate diversification to ascertainthe persistence and robustness of our preliminary results. Our two-dimensional sortingmethod employed corrects for some misclassification problems that are inherent to aone-variable approach. We thus proceed to sort sample firms according to both mergerpremium and one other distinct firm or deal characteristic and re-examine whetherpaying a high premium is detrimental to the long-run stock market wealth of acquiringfirms.

4.2.1. Method of payment and merger premium. The method of payment in mergers cansignal important information regarding the true value of acquiring and target firms underasymmetric information. For instance, an acquirer may prefer to make an equity bid ifit perceives valuation risk (i.e., if it does not feel confident about its fundamental valueestimate for the target). Paying with equity is analogous to a risk-sharing agreement bywhich the true price paid in mergers is contingent upon the future profitability of the joint



Table 3

Calendar Time Portfolio Regression (CTPR) of Bidders Sorted by Merger Premium


within a three-year period and with a deal value of one million dollars or more. The merger premium


bid price and the target market price four weeks before the initial merger announcement divided by

the same target price four weeks prior to the announcement. Acquiring firms are ranked by merger

premiums and partitioned into three portfolios according to their ranking. Low premium portfolio

comprises the lowest 30% premium paying firms. Medium premium portfolio comprises the middle

40% firms. High premium portfolio comprises the highest 30% firms. Calendar-time portfolio

regressions (CTPR) were performed for each of the sub-samples formed on the basis of merger

premium. Acquirers enter the portfolio on the effective month of the merger and remain for 12, 24,

and 36 months respectively. Calendar portfolios are rebalanced each month to include firms that have

just completed a merger and to disregard the ones that have just fulfilled 36 months. The monthly

abnormal returns are intercepts αi in the Fama and French three-factor model:

Rpt − R f t = ai + βi (Rmt − R f t ) + si SMBt + hi HMLt + εi t

Where Rpt is the calendar time portfolio return, Rft is the return on a one-month T-bill during month t,

SMB is the difference in returns of value weighted portfolios of small firms and big firms during

month t, HML is the return differential of value weighted portfolios of high and low book-to-market

ratio firms in month t, β i, si and hi are regression parameters specific to the portfolio and ε it is the

error term. The High-Low return differentials are the intercepts αp from the zero-investment portfolio

regression on the Fama and French 3-factor Model:

Rhight −Rlowt = ap +βp(Rmt −R ft ) + sp SMBt + h p HMLt + ept

Heteroscedasticity and autocorrelation adjusted t-statistics are reported in brackets.

Year All Low Medium High High−Low

(30%) (40%) (30%)

1 −0.0124a −0.0124a −0.0075c −0.0150a −0.0026[−3.66] [−2.94] [−1.78] [−2.95] [−0.46]

2 −0.0128a −0.0090a −0.0169a −0.0132a −0.0042[−4.82] [−2.76] [−4.52] [−3.26] [−0.89]

3 −0.0126a −0.0105a −0.0122a −0.0155a −0.0050[−4.83] [−3.40] [−4.01] [−4.08] [−1.31]

aDenotes significance at the 1% level.bDenotes significance at the 5% level.cDenotes significance at the 10% level.

enterprise, thus minimising the problem of adverse selection (Sudarsanam and Mahate,2003). Stock for stock payments will shift part of the (possibly negative) future returnsand risk to the shareholders of the newly created firm. Similarly, Myers and Majluf(1984) argue that the method of payment acts as an information signal. If acquiringfirm management perceives its shares as being overvalued, it will prefer to convertthese into ‘real’ assets and therefore finance acquisitions using stock. Alternatively, ifacquiring firm management believes that its shares are undervalued, it is more likelyto pay for acquisitions with cash. Furthermore, a cash offer allows the acquiring firm’scurrent shareholders to retain future returns/gains from merging. In a nutshell, a cashpayment is widely perceived as a positive information signal while stock payments are



believed to convey negative information. Moreover, Jensen (1986) argues that financingtakeovers with cash alleviates potential agency problems by releasing excess free cashflows.8 Hence, according to either theory (i.e., the signalling hypothesis or agencytheory), cash financed mergers should outperform stock financed mergers in the threeyears following mergers.9 However, if our general result (Table 3) is true/valid, it shouldremain robust after controlling for the method of payment effect.

Panel A of Table 4 reports results for method of payment and merger premium.Consistent with our initial expectation, cash offers tend to perform better than stock,especially for Low premium portfolios. We find that abnormal returns for Low + Cashacquirers are insignificant for 2 and 3 years, while Low + Stock firms earn significantlynegative monthly abnormal returns of −1.51% (at 5% level), −2.34% and −2.56%(both significant at the 1% level) in 1 to 3 years following mergers. High-Low returndifferentials are positive for all stock financed deals and negative for cash mergers. Suchdifferentials, however, are statistically insignificant except for the 3-year stock offer,where High + Stock acquirers actually outperform Low + Stock acquirers at the 10%significance level. This may suggest that, as it is widely known that financing mergerswith stock conveys negative information, paying a large stock premium may actuallysignal management confidence regarding the synergy of the deal. Our results here donot corroborate the idea that higher premiums are associated with worse performance.If anything, there is actually weak evidence that paying a higher stock premium isassociated with better post-merger stock performance. In sum, we find no proof thathigh premium paying acquirers underperform low premium-paying ones in the long-runafter adjusting for method of payment.

4.2.2. Book-to-market ratio (value vs. glamour acquirers) and merger premium. Theperformance extrapolation hypothesis suggests that investors reward/penalise firmsbased on the belief that past performance will persist into the future. More specifically,investors over-extrapolate the past positive performance of glamour firms (characterisedas having a low book-to-market ratio), thinking that it can be sustained in the future.Similarly, investors penalise value stocks (characterised as having a high book-to-marketratio) also based on the idea that poor recent performance will persist going forward. Inshort, the theory therefore predicts that the initial over extrapolation and therefore marketoverreaction to merger announcements will be corrected in time as investors reassesstheir initial expectation. It thus follows that, in M&A, value acquirers should outperformglamour acquires following mergers (Rau and Vermaelen, 1998). Lakonishok et al.(1994) show that glamour firms typically experience high past growth in cash flows andearnings, which could promote management overconfidence. On the other hand, valueacquirers are more prudent when making acquisitions. Firm status may also influence theselected method of payment in M&A. Rau and Vermaelen (1998) find that glamour firmsare more likely to use equity to finance acquisitions, a finding replicated in Sudarsanamand Mahate (2003). This is also consistent with the information asymmetry hypothesis,which postulates that glamour firm managers may know that their shares are tradingat unsustainable levels and may thus wish to convert these into real assets. Indeed,

8 Hansen (1987), Fishman (1989), and Eckbo et al. (1990) also argue that the choice ofmethod of payment in takeovers may be partially driven by agency cost considerations.9 See for example, Wansley et al. (1983), Travlos (1987), Huang and Walkling (1987), Eckbo(1988), Eckbo, Giammarino, and Heinkel (1990), Franks et al. (1988), Loughran and Vijh(1997), Rau and Vermaelen (1998), and Goergen and Renneboog (2004).



Table 4

Calendar Time Portfolio Regression (CTPR) of Bidders Sorted by Merger Premium and

Other Characteristics


within a three-year period and with a deal value of one million dollars or more. The merger premium is

defined as the four-week pre-announcement premium. It equals the difference between the initial bid

price and the target market price four weeks before the initial merger announcement divided by the same

target price four weeks prior to the announcement. Acquiring firms are ranked by merger premiums

and partitioned into three portfolios according to their ranking. Low premium portfolio comprises the

lowest 30% premium paying firms. Medium premium portfolio comprises the middle 40% firms. High

premium portfolio comprises the highest 30% firms. Calendar-time portfolio regressions (CTPR) were

performed for each of the sub-samples formed on the basis of merger premium and one other firm or

deal characteristic. Acquirers enter the portfolio on the effective month of the takeover and remain for

12, 24, and 36 months respectively. The regression procedure is identical to that described in Table 3.

Heteroscedasticity and autocorrelation adjusted t-statistics are reported in brackets.

Year Characters Low Medium High High-Low

(30%) (40%) (30%)

Panel A. Method of Payment1 Cash −0.0148b −0.0065 −0.0187a −0.0039

[−1.90] [−1.30] [−3.43] [−0.42]Stock −0.0151b −0.0105 −0.0114 0.0037

[−1.92] [−1.54] [−1.44] [0.33]

2 Cash −0.0068 −0.0160a −0.0112b −0.0044

[−1.43] [−3.32] [−2.17] [−0.66]Stock −0.0234a −0.0301a −0.0180c 0.0054

[−3.54] [−3.62] [−1.96] [0.49]

3 Cash −0.0062 −0.0092b −0.0170a −0.0108

[−1.33] [−2.20] [−2.60] [−1.51]Stock −0.0256a −0.0247a −0.0092 0.0164c

[−3.83] [−3.00] [−1.29] [1.80]

Panel B. Book-to-Market Ratio (Value or Glamour)1 Value −0.0146a −0.0060 −0.0062 0.0084

[−2.96] [−1.29] [−0.98] [1.09]Glamour −0.0051 −0.0070c −0.0153a −0.0102

[−0.94] [−1.72] [−2.56] [−1.36]

2 Value −0.0116a −0.0134a −0.0163a −0.0047

[−2.78] [−3.22] [−3.12] [−0.73]Glamour −0.0078b −0.0142a −0.0080 −0.0002

[−2.29] [−3.91] [−1.02] [−0.02]

3 Value −0.0153a −0.0144a −0.0190a −0.0037

[−3.89] [−4.17] [−3.21] [−0.56]Glamour −0.0092a −0.0146a −0.0203a −0.0111

[−2.65] [−4.15] [−2.27] [−1.22]



Table 4

Continued.

Year Characters Low Medium High High-Low

(30%) (40%) (30%)

Panel C. Relative Size between Target and Bidder1 Small RS −0.0070 −0.0055 −0.0145a −0.0075

[−1.54] [−1.40] [−2.68] [−1.22]Large RS −0.0086 −0.0149b −0.0116 −0.0030

[−1.09] [−2.26] [−1.65] [−0.29]

2 Small RS −0.0047 −0.0123a −0.0117b −0.0070

[−1.28] [−3.49] [−2.40] [−1.32]Large RS −0.0099c −0.0170a −0.0170b −0.0071

[−1.89] [−2.95] [−2.41] [−0.82]

3 Small RS −0.0101a −0.0098a −0.0145a −0.0044

[−2.69] [−3.00] [−2.67] [−0.77]Large RS −0.0088b −0.0167a −0.0182a −0.0095

[−2.11] [−3.94] [−3.52] [−1.52]

Panel D. Focused or Diversified1 Focused −0.0062 −0.0049 −0.0138b −0.0076

[−1.46] [−0.79] [−2.49] [−1.16]Diversified −0.0187a −0.0115 −0.0174a 0.0013

[−3.09] [−3.15] [−2.97] [0.17]

2 Focused −0.0086b −0.0211a −0.0159a −0.0073

[−2.31] [−3.02] [−2.68] [−1.06]Diversified −0.0096b −0.0156a −0.0182a −0.0086

[−2.20] [−4.61] [−2.81] [−1.16]

3 Focused −0.0124a −0.0041 −0.0165a −0.0041

[−2.80] [−0.69] [−3.06] [−0.70]Diversified −0.0114a −0.0164a −0.0178a −0.0064

[−3.17] [−4.26] [−3.42] [−1.38]


Dong et al. (2006) argue that firms with low book-to-market ratios are more likelyto be overvalued. We now control for acquirer status (value or glamour) to verify therobustness of our finding that long-run underperformance is not caused by high mergerpremiums paid in M&A.

Panel B of Table 4 reports results for sub-portfolios sorted by both book-to-marketratio and merger premium. We can see that, by and large, both glamour and valueacquirers earn negative abnormal returns in the 3 years following mergers. For example,Low + Value earns a significant negative monthly average abnormal return of −1.53%and High + Value loses a monthly −1.9% in three-year after mergers; Low + Glamourearns a −0.9% monthly abnormal return and High + Glamour experiences a −2.0%



monthly loss 3 years following mergers. All but one High-Low return differential arenegative but such differentials are statistically insignificant. For instance, the High-Lowreturn differential for value acquirers is −0.37% with a t-value of −0.56 and the High-Low differential for glamour bidders is −1.11% with a t-statistic of −1.22 in 3-yearfollowing mergers. These results indicate that high premium paying acquirers do notunder perform low premium paying acquirers in the 3 years following mergers aftercontrolling for acquirers’ value/glamour status.

4.2.3. Relative size and merger premium. In examining the wealth effects of mergerson acquiring firms, relative size (RS) may be a more relevant factor than size alone.This is the case because very large bidders may acquire puny targets, which will havean immaterial financial and/or operating impact on the acquirer. Numerous studieshave been carried out to examine the impact of the relative size of targets to bidderson acquiring firms’ post-merger stock performance. Ang and Kohers (2001) postulatethat the relative size of targets is a critical determinant of bidders’ post-merger stockperformance. Asquith et al. (1983) find that acquiring firm abnormal returns depend onthe relative size of the target. Fuller et al. (2002) show that the larger the relative size oftargets (in the acquisition of publicly-traded firms), the lower the acquirers’ abnormalreturns. Further, evidence suggests that the larger the relative size of targets, the morelikely the acquirer will finance mergers using stock (e.g., Myers and Majluf (1984) andDeAngelo et al. (1984)). Intuitively, larger relative size targets may also require morediligent post-merger integration work. In light of the above evidence, we control forboth relative size and merger premium in our study.

In panel C of Table 4, we again observe negative post merger abnormal returns acrossthe board of sub-portfolios sorted by relative size and merger premium. All the High-Low return differentials are negative but statistically insignificant. For example, Low +Small RS acquirers earn a negative monthly abnormal return of −1.01% while High +Small RS portfolio earns a negative monthly abnormal return of −1.45% 3 years afterthe merger, all significant at the 1% level. The High-Low return differential, however,is −0.4% with a t-statistic of −0.77. Conversely, Low + Large RS acquirers experiencea negative monthly abnormal return of 0.9% while the High + Large RS portfolioloses a monthly −1.82% 3 years after mergers; significant at the 5% and 1% levelsrespectively. But once again, the High-Low monthly return differential of −0.95% isstatistically insignificant. Hence, we do not find that High premiums lead to significantlyworse long-run stock performance than Low premiums after controlling for relative sizeof targets to bidders.

4.2.4. Corporate diversification and merger premium. Can managers use M&A todiversify more efficiently than individual investors? It is widely believed that the extentof the value creation potential from mergers is a function of the existing synergisticpotential between a bidder and its target. Shelton (1988) writes that ‘value is createdwhen the assets are used more effectively by the combined entity than by the target andbidder separately’ and finds that M&A that enable the bidder to access new but relatedmarkets create the most value with the least variance. Furthermore, diversifying mergersmay possibly be driven by management overconfidence as managers may overestimatetheir expertise in unrelated target firm industries. Maquiera et al. (1998) back the ideathat corporate diversification strategies destroy value. In a nutshell, the literature seemsto reinforce the notion that diversification is best left up to individual investors.



Panel D of Table 4 reports the results for sub-portfolios sorted by both the extentof merger premium and diversification. Again, all High-Low return differentials arestatistically insignificant. For instance, the group of Low + Focused acquirers earns anegative monthly abnormal return of −1.24% while the High + Focused portfolio loses1.65% a month on average 3 years after mergers, all significant at the 1% level. TheHigh-Low return differential of −0.4% is statistically insignificant (t-statistic of −0.7).On the other hand, after 3 years, the Low + Diversified portfolio experiences a monthlyloss of −1.14% while the High + Diversified earns a negative monthly abnormal returnof −1.78%, once again significant at the 1% level. But the High-Low return differentialof −0.64% is statistically insignificant. Thus far, we are unable to conclude that payinga higher premium hurts the post-merger stock performance of acquiring firms aftercontrolling for the corporate diversification effect.

4.3. Do high premium paying acquirers under perform around mergerannouncements? The short-run evidence

The picture that emerges is that UK public acquirers tend to experience significantwealth losses in the 3 years following mergers. More importantly however, we haveshown that high merger premiums paid are unlikely to be responsible for this long-rununderperformance. Given that, in our sample, the average merger premium is 9 timesas large for High acquirers relative to Low acquirers, it may well be that a high mergerpremium actually proxies for synergies between the acquirer and its target. We thus focusour analysis on how the extent of the merger premium paid impacts announcement periodstock returns.

We examine 3- and 5-day announcement period cumulative abnormal returns (CARs)for targets, acquirers, and combined firms. We first examine the full sample and thenproceed to analyze results for sub-samples sorted by the extent of merger premiumspaid (i.e., Low 30%, Median 40%, and High 30%), and finally test for the statisticalsignificance of return differentials between the High and Low premium portfolios.

4.3.1. Cumulative abnormal returns of target firms. It has become a stylised fact thattarget firms benefit generously from mergers due to high premiums paid on averageby acquirers. Panel A of Table 5 shows that for the full sample, target firms earnhighly significant CARs of 16.3% and 17.6% in the 3 and 5 days surrounding mergerannouncements. Turning our attention to sub-samples based on merger premiums paid,it is unsurprising that sub-portfolios earn a higher CAR the higher the merger premiumpaid. Abnormal returns for all sub-samples are massive and all significant at the 1%level. For instance, in the 5-day event window, target firms receiving Low premiums earna significant CAR of 6.4%, compared to 27.9% for targets receiving High premiums. Aswould be expected, High-Low return differentials for both 3- and 5-day event windowsare large (19.1% and 21.4% respectively) and statistically significant at the 1% level.

4.3.2. Cumulative abnormal returns of acquiring firms. If investors are not system-atically wrong, the stock market reaction to the bidding firm around the mergerannouncement should incorporate any value changes from the merger. Panel B ofTable 5 shows that for the full sample, acquirers earn a negative CAR of −1.3% and−1.4% in the 3 and 5 days surrounding merger announcements; both are significant at the1% level. This result illustrates that markets react negatively to merger announcements ingeneral. For sub-samples, in 3 and 5-day event windows, we see that Low acquirers earn



Table 5

Short-run Cumulative Abnormal Returns (CARs) of Targets, Bidders, and the Combined

The sample consists of 396 public targets and 396 UK public bidders that have acquired one or

more public target firms within a three-year period and with a deal value of one million dollars or

more. The merger premium is defined as the four-week pre-announcement premium. It equals the

difference between the initial bid price and the target market price four weeks before the initial merger

announcement divided by the same target price four weeks prior to the announcement. Acquiring

firms are ranked by merger premiums and partitioned into three portfolios according to their ranking.

Low premium portfolio comprises the lowest 30% premium paying firms. Medium premium portfolio

comprises the middle 40% firms. High premium portfolio comprises the highest 30% firms. We

calculate abnormal return based on the market-adjusted returns:

ARi = Ri − Rm

where Ri is the return on event firm i and Rm is the value-weighted market index return. The test

statistics used are both the conventional parametric t-test and the nonparametric wilcoxon test. The

parametric t-values are reported in square brackets. The nonparametric p-values are reported under the

t-statistics in parentheses.

Day All Low Medium High High-Low

(30%) (40%) (30%)

Panel A. Target Firm0.1632a 0.0641a 0.1678a 0.2546a 0.1905a

(−1, +1) [17.17] [4.96] [14.76] [11.96] [7.65](0.000) (0.000) (0.000) (0.000) (0.000)

0.1757a 0.0643a 0.1808a 0.2785a 0.2142a

(−2, +2) [17.37] [4.13] [15.86] [12.83] [8.02](0.000) (0.000) (0.000) (0.000) (0.000)

Panel B. Bidding Firm−0.0127a −0.0138b −0.0126b −0.0117 0.0021

(−1, +1) [−3.37] [−2.05] [−2.26] [−1.52] [0.21](0.001) (0.030) (0.039) (0.124) (0.629)

−0.0141a −0.0181b −0.0118c −0.0134 0.0047(−2, +2) [−3.32] [−2.42] [−1.86] [−1.56] [0.42]

(0.002) (0.017) (0.078) (0.269) (0.318)

Panel C. Combined Firm (Target and Bidder)0.0291a 0.0016 0.0341a 0.0464a 0.0448a

(−1, +1) [6.82] [0.26] [5.55] [5.13] [4.07](0.000) (0.791) (0.000) (0.000) (0.000)

0.0301a −0.0083 0.0379a 0.0534a 0.0617a

(−2, +2) [5.98] [−0.97] [5.70] [5.08] [4.55](0.000) (0.698) (0.000) (0.000) (0.000)




a negative CAR of −1.38% and −1.81% respectively (both significant at the 5% level).Next, medium acquirers earn a CAR of −1.26% (3 day) and −1.18% (5 day), both aresignificant at the 5% and 10% levels respectively. In contrast, High acquirers do notexperience any significant losses in the 3- and 5-day event windows. Thus, we find weakevidence that acquirer performance improves as the level of premiums paid increases.High-Low return differentials are positive albeit statistically insignificant. This result atleast indicates that higher premiums do not lead to worse announcement period stockmarket returns for acquiring firms. This finding also reinforces the assertion that highpremiums may indeed proxy for synergy reserves between targets and acquirers.

4.3.3. Cumulative abnormal returns of combined firms. It is widely argued that thecombined firm abnormal return (the weighted average CAR) best reflects the true wealtheffect (i.e., economic benefit or detriment) of M&A. If M&A actually create value andresult in more than just a simple transfer of wealth between the acquirer and the target,it then follows that the combined firm will earn a positive CAR during the mergerannouncement period. Panel C of Table 5 shows that for the whole sample, combinedfirms earn a positive value-weighted CAR of 2.91% and 3.01% in both the 3- and 5-dayevent windows, with results significant at the 1% level; this is consistent with Campa andHernando (2004). If merger premiums better proxy for synergies than overpayments, wewould expect the combined announcement period CAR to be positively correlated withthe extent of the merger premium paid. Our evidence indeed shows that the higher thepremium the larger the combined CAR. The High-Low return differentials are 4.48%and 6.17% for 3- and 5-day event windows respectively, both are statistically significantat 1% level. We therefore find clear evidence that merger premiums may better proxy fordeal synergies. The bigger picture that emerges, however, is that premiums, both in theshort- and long-run, are unlikely perpetrators of poor post-merger stock performance ofacquiring firms.

4.4. General remarks

Contrarily to our ex ante expectation, we do not find any evidence that high premiumpaying acquirers under perform the low premium paying ones in up to 3 years followingmergers, even after controlling for a variety of known firm and deal characteristics.Our short-run analysis actually suggests that merger premiums may better proxy forthe amount of synergies between the acquirer and its target; this explanation standsin sharp contrast with the hubris hypothesis. Also, in the short-run, we observesignificantly positive combined CARs for the high premium paying acquirers comparedto insignificant combined CARs for the low premium paying ones. If the combinedgains earned at the announcement period by High acquirers are real and permanent, wewould not expect to see any long-run performance differentials between high and lowsub-portfolios. This may well serve to explain why our long-run (1 to 3 years) returndifferentials between High and Low portfolios are largely insignificant. All in all, forour sample of UK acquirers, it is clear that high premiums paid in mergers should notbe blamed for the widely documented post merger underperformance puzzle.

5. Conclusion

In this paper, we examine whether high premiums paid in mergers are the culpritfor acquirers’ subsequent underperformance. In particular, we test the hypothesis that



overpaying, as proxied by high merger premiums paid, may at least partly be responsiblefor the widely documented post-merger underperformance puzzle. Our research ismotivated by the growing concern that M&A destroy value for acquirer shareholdersand that combined firms are unable to successfully marry and extract projectedsynergies, perhaps due to idealistic pre-merger expectations or bidding firm managementoverconfidence when pursuing M&A. Although our results suggest mergers do notbenefit shareholders in the long-run, a finding which is consistent with the bulk of theliterature, we find no evidence that high premiums paid are in fact responsible for thislong-run underperformance, and our result is robust after controlling for various firmand deal characteristics. In fact, our short-run analysis suggests that merger premiumsmay well proxy for synergies between targets and bidders.

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How Much Is Too Much: Are Merger Premiums Too High?