Full length articleAcquirers’ earnings management ahead of stock-for-stock bids in ‘hot’ and ‘cold’ markets☆
Introduction
The accounting literature has found evidence for several countries that acquirers in stock-for-stock M&A manage earnings upwards ahead of a bid (Botsari and Meeks, 2008, Erickson and Wang, 1999, Gong et al., 2008, Higgins, 2013, Louis, 2004). A rationale for such behavior is that, if stock markets are only semi-strong efficient, inflated earnings may misinform the market, increasing the price of the bidder’s stock – the currency of the deal. Income-increasing accrual manipulation in the period preceding the bid announcement may then achieve a more favorable exchange ratio for stock, and so secure the target’s earnings more cheaply.
Other literatures have concluded that, when stock prices are high and rising, M&A is higher, more M&A is financed with stock, market sentiment and stockholders’ perceptions of information appear to change, and in these circumstances new (arbitrage) motivations for M&A emerge.
Amel-Zadeh et al., 2016, Nelson, 1959, and Scherer and Ross (1990) have charted the successive waves in M&A over the last century and their positive association with fluctuations in stock market prices. Fig. 1a, Fig. 1b illustrates the most recent two waves in the UK – the focus of this paper. One takeover wave in the UK market peaked during the second quarter of 2000, when the value of announced deals (see Fig. 1a) in that quarter alone reached the record level of c. £151 billion, while the third quarter of 2000 saw a reduction of more than 75% (in the run-up to the former period, the FTSE All Share index soared to more than 3200, having increased by more than 55% since the beginning of 1997). The next merger wave developed in 2003 and reached its peak in terms of the number of announced deals (see Fig. 1b) during the third quarter of 2007, after which the number of transactions decreased by almost 30%.
Nelson’s (1959) study found that stock-for-stock finance was heavily used to finance deals in merger waves. And, more recently, the acquisition wave which developed in the 1990s – the greatest takeover wave in history in terms of both size and geographical dispersion1 – was characterized by the overwhelming use of stock as a means of payment (Andrade et al., 2001) and accompanied rising prices.
Shiller (most recently 2015) has contributed a series of studies on ‘irrational exuberance’, showing that the fluctuations in stock market prices are much greater than is warranted by the variation in subsequent real dividends which they are expected to reflect: investors’ perceptions of information relating to stock price are distorted in ‘hot’ markets – stocks are temporarily mis-valued. And Shleifer and Vishny (2003) develop their theory of acquisition for these circumstances: in this theory, M&A can be seen as a form of arbitrage by rational managers operating in markets which are not strong-form efficient. Bidders use their own temporarily inflated stock as currency even if the target’s stock is – in a ‘hot’ market – also overvalued: “acquisitions are made by overvalued acquirers of relatively less overvalued targets” (p.305).
In these circumstances, Shleifer and Vishny (2003) point also to “a powerful incentive for firms to get their equity overvalued, so that they can make acquisitions with stock” (p.309). In this case, acquirers do not just exploit arbitrage opportunities: they can create additional opportunities via earnings management.
This paper explores possible interlinkages between over-pricing, earnings management, merger and means of payment in different phases of the stock market and merger cycles. We analyze experience in periods of rising stock prices and vigorous merger activity (1997–2000, 2003–2007) in comparison with periods (2000–2002, 2007–2010) in which stock prices were lower and M&A activity fell sharply.
We analyze UK acquirers. The London Stock Exchange represents the world’s second largest takeover market. The UK accounts for the large majority of European deals (Faccio and Masulis, 2005), while the European market is of similar size to that in the US (Martynova and Renneboog, 2008). During the period under investigation, the UK exhibited the most intense acquisition activity world-wide, with UK acquirers accounting on average for approximately 16% of the global value of cross-border acquisitions (UNCTAD, 2015). Fig. 1a, Fig. 1b charts the waves of London M&A volumes and values, as well as of stock prices, in the period we study.
The paper’s hypotheses and empirical design differ from those of other studies that have analyzed earnings management ahead of M&A for the US market. For example, Louis (2004) focuses on providing an explanation for the post-merger underperformance anomaly and finds that the reversal of the effects of pre-merger earnings management is a significant determinant of the long-run negative performance of stock-for-stock acquirers.
More recently, Gong et al. (2008) study the association between stock-for-stock acquirers’ pre-merger abnormal accruals and post-merger announcement lawsuits and find that the long-term market underperformance of stock-for-stock acquirers is largely limited to litigated acquisitions. In the UK case, institutional arrangements differ from those in the US, and in our sample period litigation by target shareholders was rarely, if ever, observed. Class/collective actions have only been allowed since 2015, after our study period (Ashurst, 2017); and even then, because in the UK investors have to opt into an action, rather than opt out as in the US, fewer investors join an action and such litigation is less effective (Section 2 discusses our research on alternative recourse for disaffected shareholders of target firms).
Hence, while the aforementioned US studies emphasize the post-merger consequences of earnings management and/or address issues that may not be as relevant for UK acquirers, the current study intends to analyze the incentives for earnings management in the first place and the reasons for which market participants can or cannot factor and undo the stock price effects of earnings management.
In particular, the paper addresses three related research questions. First, it tests empirically the suggestion from the stock-market-driven-acquisitions literature that earnings management is expected to be more pronounced during booming (‘hot’) stock market and merger-wave phases, when the incentives to take advantage of the overall market conditions are more intense. We find that earnings management ahead of stock-for-stock bids is indeed largely associated with phases of high market valuation and rates of M&A.
Second, it responds to the criticisms in Fields et al., 2001, Walker, 2013 that the results of prior studies of earnings management ahead of share bids are ‘unconvincing’, exactly because they do not test whether accrual manipulation had the intended impact on the acquirer’s share price. In the present study, we specifically address the issue of market reaction around the acquirers’ earnings-release date, and how this reaction relates to bidders’ earnings management behavior.
Therefore, apart from examining the extent to which high stock prices can affect the acquirers’ propensity to manage earnings upwards ahead of stock-for-stock M&A, we further test a related hypothesis and find that the ability of market participants to ‘see through’ and ‘reverse out’ the effects of earnings management depends on the prevailing market conditions. We find evidence that in hot markets positive discretionary accruals are associated with positive abnormal returns for stock-for-stock acquirers – with share prices being inflated in the period preceding the bid announcement. But we do not find this association in phases of low M&A activity.
The third question follows the literature initiated by Myers and Majluf (1984), highlighting the different signalling implications associated with the method of payment chosen to perform an acquisition – i.e. a share offer signals to the market that the bidding firm believes its own stock to be overvalued. Therefore, if investors can be misled by earnings management in the pre-bid period, the question arises whether there is any evidence of correction of this prior mispricing at bid announcement, when investors might (according to the signalling theory) be alerted to these acquirers’ pre-existing overvaluation. The findings of the paper are consistent with the earlier conclusion that the market reaction to the announcement of a share bid depends on whether the latter takes place during a phase of high or low M&A activity. Inflated prices tend not to be corrected in hot markets.
The paper’s main contribution, then, is to introduce market-wide developments into the analysis of earnings management ahead of stock-for-stock M&A. Just as Shleifer and Vishny (2003) argue that executives take advantage of temporary overvaluation of their stock in a hot market to make acquisitions on favorable terms, so also we find that executives in hot markets tend more often to manage earnings upwards in advance of a stock-for-stock bid. Such markets tend not to ‘see through’ such earnings management, and bidders are, on average, rewarded with a higher share price, reducing the cost of an acquisition.
Indeed, the paper’s findings suggest that share acquirers engaging more aggressively in earnings management benefit from a relative increase in market value by almost 2.4% on average, enabling them to issue fewer (higher-priced) shares to target shareholders to achieve a given cash-equivalent consideration. In turn, other things equal, each one percent reduction in new shares issued would add approximately 0.3 percent to the amalgamation’s EPS, cushioning the post-merger earnings dilution. The economic benefits achieved by engaging in earnings management during hot markets are further reinforced by the evidence that in such hot markets, the higher share price is not typically corrected in response to the signal embodied in a bid announcement.
The remainder of the paper is organized as follows: Section 2 discusses earnings management in the context of the market efficiency theory; Section 3 presents the literature review and sets the hypotheses to be tested; Section 4 describes the sample and the research design adopted in the paper; Section 5 presents and discusses the empirical findings; while Section 6 concludes.
Section snippets
Market efficiency, earnings management devices and their detection
For the executives of an acquirer the potential benefit of an earnings management device is achieved if it fools shareholders; and the potential cost arises if it is detected and punished. The benefits can be achieved and the costs avoided if markets are no more than semi-strong efficient; if the device is opaque; and if it is compliant with corporate law and accounting regulations.
If stock markets were strong-form efficient in Fama’s (1970) categories – share prices reflecting all available
Earnings management, stock-for-stock M&A and ‘hot’ markets
A number of studies for a range of countries provide evidence that bidders employ income-increasing accrual management practices prior to the announcement of stock-for-stock acquisitions (Botsari and Meeks, 2008, Erickson and Wang, 1999, Gong et al., 2008, Higgins, 2013, Louis, 2004). The implicit rationale for this behavior is that, if markets are only semi-strong efficient in Fama’s (1970) terms, opaque earnings management may inflate stock prices, securing a more favorable exchange ratio for
Sample selection and descriptive statistics
The study analyzes M&A transactions that were announced and completed by UK acquirers between January 1, 1997 and December 31, 2010. Sample transactions were selected on the basis of the following criteria:
- (1)
The acquirer is (or was at the time of the acquisition) a UK company listed on the London Stock Exchange.
- (2)
The acquirer is a non-financial, non-utility company.
- (3)
The bidder acquired a majority interest in the target company or ended up holding a majority interest as a result of the deal.
- (4)
The
Earnings management and merger waves
Table 2 reports discretionary accrual estimates12 over a five-year period (i.e. for the two years preceding the announcement of the deal and for the three years following its completion) and disaggregates the earnings management evidence according to the phase (high vs. low M&A activity) during which the bid announcement takes place.
The reported results are consistent
Summary and conclusions
The paper explores the inter-relation between pricing, method of payment and earnings management incentives in different merger-activity phases. Prior studies have investigated the earnings management hypothesis ahead of share-swap acquisitions. The results in this paper show that the earnings management evidence for share acquirers is mainly driven by periods of high market valuation and M&A activity.
The fact that cash acquirers with comparable PTB ratios do not exhibit income-increasing
Acknowledgments
We are thankful to Tim Bellis, Owain Evans and Geoffrey Whittington for valuable advice and suggestions. We gratefully acknowledge the comments of two anonymous referees and JAPP Editors Lawrence Gordon and Martin Loeb.
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The views expressed in this paper are the authors’ and do not necessarily reflect those of the European Investment Fund.