Market Misvaluation and Merger Activity: Evidence from Managerial Insider Trading

Transcription

1 Paper 2 of 2 USC FBE FINANCE SEMINAR presened by Mehme Akbulu FRIDAY, Sepember 16, :00 am 11:30 am, Room: JKP-104 Marke Misvaluaion and Merger Aciviy: Evidence from Managerial Insider Trading Mehme E. Akbulu 1 Marshall School of Business Universiy of Souhern California ABSTRACT This paper ess he empirical predicions of he marke misvaluaion heory of mergers advanced by Rhodes-Kropf and Vishwanahan (2004) and Shleifer and Vishny (2003) using daa on managerial insider rading around merger announcemens. To he exen ha managerial rading is moivaed by misvaluaion, I find consisen differences in he merger characerisics and longrun reurns of overvalued and undervalued firms. Overvalued firms are more likely o conduc sock mergers, have high pre-merger bu negaive pos-merger excess long-run reurns and receive negaive marke reacion o heir acquisiion announcemens. My resuls suppor he heory ha marke misvaluaion affecs merger aciviy. Firs Version: 01/17/2004 Las Revised: 01/10/2005 I hank Harry DeAngelo, John Masusaka, Kevin Murphy, Micah Officer, Oguzhan Ozbas and seminar paricipans a USC for helpful suggesions and USC for financial suppor. 1 Ph.D. candidae in Finance, Marshall School of Business, Universiy of Souhern California, 701 Hoffman Hall, Los Angeles, CA 90089, Phone: , Fax: , akbulu@usc.edu

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3 "Someimes here is confusion beween wrie-offs and he creaion and desrucion of value. Given ha he acquisiions were virually [all] paid in shares, no cash, his noncash charge does no represen any value desrucion. Jean-Marie Messier, chief execuive of Vivendi Universal, announcing a 15.7bn wrie-off, mosly linked o is $34bn acquisiion of Seagram and 12.5bn purchase of Canal Plus. DO MANAGERS ENGAGE IN COSTLY ACQUISITION SPREES FOR STOCK when hey perceive heir own company sock as overvalued? While academics and invesors alike sared eneraining his possibiliy heavily afer winessing he gian sock-merger deals of lae 1990s, Jean-Marie Messier, who as he CEO of he French waer uiliy company Vivendi engaged in a $100 billion acquisiion spree ha almos ended in bankrupcy, became -o bes of my knowledge- he firs o publicly admi i. Many of he gian sock-merger deals of he lae 1990s urned ou o be immensely valuedesroying for he acquirer shareholders. Moeller, Schlingemann, and Sulz (2003) show ha from 1998 hrough 2001, a small number of acquisiion announcemens by firms wih exremely high valuaions are responsible for a $240 billion loss in acquirer firm value. A paricularly famous example is he AOL-Time Warner merger, which wih a deal value of $156 billion, was he bigges merger in corporae hisory and resuled in a record value desrucion of $31.2 billion for AOL a he announcemen of he merger. 2 AOL paid a 70% premium for Time Warner using is sock as he acquisiion currency. Despie his large premium and he loss of value a he announcemen, many observers believe oday ha AOL go an excellen deal as is sock was overvalued:...in early 2002 AOL Time Warner said i would ake a $54 billion charge he larges in U.S. business hisory because he value of he sock i used o buy Time Warner had plunged. Tha was a aci admission ha he deal had been overvalued (Washingon Pos, 7/19/2002). 2 Calculaed as he dollar change in AOL s marke value in excess of he dollar change in CRSP value weighed marke index from days -2 hrough day +1 relaive o he merger announcemen day. 2

4 The posiive relaionship beween high sock marke valuaions and merger aciviy is welldocumened: i has been known as early as Nelson (1959) ha merger aciviy peaks in periods of high marke valuaions. More recenly Andrade e al. (2001), confirms Nelson's findings and furher shows ha he preponderance of sock acquisiions is greaer in higher valuaion markes. The eagerness of acquirers o use heir sock as acquisiion currency during he imes of high marke valuaion led researchers o argue ha hey migh be overvalued. For example, Loughran and Vijh (1997) and Rau and Vermaelen (1998) presen evidence from acquirer long-run reurns and argue ha overvalued bidders pay wih equiy o acquire arges a a bargain price whereas undervalued bidders choose cash. Two recen heories aemp o model he effec of sock marke valuaions on merger aciviy. Shleifer and Vishny (2003) propose a model wih raional managers and an irraional sock marke where mergers are driven purely by invesor misvaluaion and can occur even in he absence of any synergies. In heir model, arge managers maximize heir own shor run privae gain insead of long-erm shareholder value, making hem likely o accep sock bids by he overvalued acquirers. Rhodes-Kropf and Vishwanahan (2004) propose a model where markes are raional bu poenial marke value deviaions from fundamenal values on boh sides of he ransacion can raionally lead o a correlaion beween sock merger aciviy and marke valuaion. Alhough differen in heir assumpions abou marke raionaliy, boh Shleifer and Vishny (2003) and Rhodes-Kropf and Vishwanahan (2004) models yield he same empirical predicions. However any es of hese empirical predicions firs has o deal wih he problem of measuring misvaluaion. One way of measuring wheher he acquirer was overvalued a he acquisiion dae is o look a pos-even long-run abnormal sock reurns. 3 However as Dong e al. (2003) noe, here has been much debae abou wheher evidence of abnormal long-run poseven average reurns implies sock marke inefficiency wih respec o he even (see Fama (1998), Loughran and Rier (2000), Daniel, Hirshleifer and Teoh (2002), Michell and Safford (2001)). Also in long-run even sudies he resuls are highly sensiive o he choice of normal reurn benchmarks and he mehod for compounding reurns; see e.g. Barber and Lyon (1997). 3 See Frank, Harris and Timan (1991), Loughran and Vijh (1997) and Rau and Vermaelen (1998) 3

5 Two recen sudies aemp o es he misvaluaion heories by measuring misvaluaion using accouning muliples. Dong e al. (2003) define marke misvaluaion as he discrepancy beween he marke price and a conemporaneous measure of he fundamenal value. To measure he fundamenal value hey use he raio of book value of equiy o price (B/P) and he raio of residual income model value o price (V/P). Rhodes-Kropf e al. (2004) use marke-o-book (M/B) as a measure of misvaluaion. They decompose M/B ino a misvaluaion componen and a growh componen and calculae measures of fundamenal value by running cross secional regressions of marke values on accouning fundamenals each year. While boh sudies find supporing evidence for he misvaluaion heory, heir dependence on accouning variables o measure misvaluaion raises some concerns. Firs, accouning variables are easily disored by non-economic evens like managemen manipulaion and changes in reporing requiremens. Second, hey migh be proxying for effecs oher han misvaluaion. For example he raio of book value of equiy o price (B/P) may also capure risk (see Daniel, Hirshleifer, and Subrahmanyam (2001) and Barberis and Huang (2001)), growh opporuniies, informaion asymmery or managerial discipline. Dong e al. (2003) acknowledge his and use V/P as a supplemenary measure. However hey noe ha here is sill he possibiliy ha V/P migh be proxying for risk. Rhodes-Kropf e al. (2004) criicize Dong e al. (2003) for no separaely idenifying changes in growh opporuniies, expeced reurns and misvaluaion. The variable hey use is M/B, which is a well-known proxy for fuure growh opporuniies. They aemp o purify i by subracing he growh componen from M/B. However heir fundamenal value measures are derived from accouning variables and o he exen hey canno capure he rue value, heir measures of misvaluaion will also reflec ime-varying risk premia and growh opporuniies. In his paper, I es he marke misvaluaion heory of mergers using he informaion conained in he managerial insider rades prior o he mergers. My analysis consiss of wo main pars: Firs, I presen evidence on he informaion conen of managerial insider rading and show ha managers rade opporunisically prior o merger announcemens. Second, I consruc a misvaluaion measure using he level and direcion of managerial insider rading prior o mergers and use i o es he empirical predicions of he marke misvaluaion heory. Shleifer and Vishny (2003) explicily menion managerial insider rading as a possible consequence of being 4

6 overvalued and o he bes of my knowledge his is he firs paper which uses managerial insider rading o es he marke misvaluaion heory of mergers. Unlike he misvaluaion measures used by Dong e al. (2003) and Rhodes-Kropf e al. (2004), my measure does no require he calculaion of he rue value of he firm. Insead, I measure he perceived misvaluaion by he managers. I argue ha firms where managers are ne-sellers in company sock in heir privae porfolios are perceived o be overvalued by heir managers whereas firms where managers are ne-buyers are perceived o be undervalued. Accordingly, higher levels of ne-selling relaive o he common sock holdings of he managers represen higher levels of overvaluaion and higher levels of ne-buying represen higher levels of undervaluaion. My misvaluaion measure is neverheless closely relaed o pricing muliples like B/P and M/B used by Dong e al. (2003) and Rhodes-Kropf e al. (2004), bu i provides a more direc way of measuring misvaluaion. Recen research shows ha managerial rading aciviy is no randomly disribued among value and growh socks. Rozeff and Zaman (1998) show ha managers in growh firms end o sell more equiy han managers in value firms, i.e. hey have conrarian views abou heir firms. They inerpre his as evidence ha he marke overvalues growh socks and undervalues value socks. Jener (2003) finds evidence for he conrarian naure of managerial rading even afer conrolling for non-informaion moives for rading by keeping managerial ownership levels and compensaion grans consan. In shor, Rozeff and Zaman (1998) and Jener (2003) documen he relaion beween managerial rading and pricing muliples, while Dong e al. (2003) and Rhodes-Kropf e al. (2004) use pricing muliples o measure marke misvaluaion. My approach measures marke misvaluaion direcly from managerial rades wihou he inermediae sep of using he pricing muliples. This resuls in a more naural measure which does no suffer from he limiaions of price muliples described above. Cenral o my measure is he informaion conen in he insider rades of he managers. The informaion conen of insider rading has been well documened (see Jaffee 1974, Finnery 1976 and Seyhun 1986, 1988). Seyhun (1986) shows ha insiders earn an average 3% abnormal reurn on heir ransacions. Sudies examining insider rading around imporan corporae announcemens indicae significan changes in rading paerns before he public announcemen. 5

7 Penman (1982) shows ha corporae insiders ime heir rades relaive o announcemens of earnings forecass and earn posiive abnormal reurns. Ellio e al. (1984) find evidence of increased buying prior o exremely favorable earnings announcemens and of increased selling prior o exremely unfavorable earnings announcemens. Lee e al. (1992) find increased buying and reduced selling prior o repurchase ender offers. Karpoff and Lee (1991) find increased selling prior o seasoned offerings of common sock. Seyhun (1990b) analyzes he insider rades of acquirer firm managers around mergers and ender offers and finds ha managers increase heir ne purchases prior o good acquisiions (as characerized by announcemen abnormal reurn) and prior o bad acquisiions here is an insignifican increase in ne selling. He inerpres his as evidence ha here are some op execuives who sell sock in heir own firms prior o value-decreasing acquisiions. Recenly Akbulu (2005a), using a sample of 2,105 mergers from 1983 o 2001 shows ha acquirer-firm managers rade opporunisically prior o he merger announcemens by abnormally increasing heir sales prior o sock mergers and bad mergers and heir purchases prior o cash mergers and good mergers. 4 He inerpres hese resuls as evidence ha managers rade opporunisically prior o he mergers o ake advanage of he insider informaion he posses abou he value of heir firm. These findings also confirm Shleifer and Vishny (2003) s predicion ha here would be increased insider selling prior o sock acquisiions, because hose deals are more likely o be overvalued. I classify acquirer and arge firms as overvalued or undervalued based on he level and direcion of ne rading by he managers in he year prior o he merger announcemen. To he exen ha managerial rading is moivaed by misvaluaion, I find persisen differences in acquisiion characerisics, mehods of paymen used, announcemen abnormal reurns and long run abnormal sock reurns of he firms perceived as overvalued and undervalued by heir managers. Firs, consisen wih he marke misvaluaion heory, overvalued acquirers prefer sock as he mehod of paymen whereas undervalued acquirers prefer cash. Moreover, acquirers are more likely o use sock when he arge is overvalued. 4 Bad and Good mergers are characerized as having a 4-day announcemen cumulaive abnormal reurn of more han less han -10% and more han 10% respecively. 6

8 Second, acquirer and arge announcemen period abnormal reurns are negaively correlaed wih he degree of acquirer and arge overvaluaion and his correlaion is sronges in sock mergers. The mos overvalued acquirers and arges in sock mergers have 2.7% and 6.3% lower average announcemen cumulaive abnormal reurns (CAR) respecively han he mos undervalued ones. Moreover, arge overvaluaion grealy affecs acquirer announcemen abnormal reurns; acquirers in sock mergers ha buy he mos overvalued arges have 4.2% lower average announcemen CAR han hose ha buy he mos undervalued arges. These resuls sugges ha marke a leas parially correcs for preexising acquirer and arge misvaluaion a he merger announcemen. Third, overvalued acquirers have higher pre-merger bu lower pos-merger excess reurns han undervalued acquirers and his difference is sronges in sock mergers. The mos overvalued acquirers underperform he mos undervalued acquirers by 9.4% (0.78% per monh) in all mergers and 19% (1.58 % per monh) in sock mergers one year afer he merger using calendar ime porfolio regressions mehod. Moreover, he underperformance in sock mergers is robus o using value-weighed reurns insead of equal-weighed reurns, using a differen asse pricing model and using Buy-and-Hold abnormal reurns mehod insead of calendar-ime porfolio abnormal reurns. These findings documen an evenual correcion of he pre-merger misvaluaion in he long run. Finally, consisen wih he predicions of he Shleifer and Vishny (2003) model, overvalued acquirers make more diversifying acquisiions because when hey are overvalued, here is a good chance ha heir indusry is also overvalued. Targes require higher bid premiums when hey are undervalued and are more likely o resis offers from undervalued acquirers confirming he predicion of Shleifer and Vishny (2003) ha arge resisance o akeover bids benefis arge shareholders. Overall, my resuls are supporive of he marke misvaluaion heory of mergers. The res of he paper is organized as follows. Secion I describes he daa and mehod. Secion II ess he empirical predicions of he marke misvaluaion heory. Secion III concludes. 7

9 I. Daa and Mehod A. Sample Descripion I searched he Securiies Daa Corporaion (SDC) Plainum Mergers & Acquisiions daabase for compleed mergers beween public companies from January 1983 o December 2001 where: The acquirer owns less han 5% of he arge prior o he acquisiion and buys he res wih he acquisiion Daa on mehod of paymen, wheher he deal was hosile or no and bid premium is available. There is price and reurn daa for boh acquirer and he arge in he Universiy of Chicago s Cener for Research in Securiy Prices (CRSP) daabase There are no oher corporae announcemens like share repurchases, sock splis ec. concurren wih he merger announcemen These requiremens resul in an iniial sample of 2,564 mergers. Nex I search for he insider rades of he acquirer and arge firms managers in he Thomson Financial Insiders Daabase (IDF). To ensure ha each firm has enough insider daa coverage prior o he merger I require he firs enry in he IDF daabase for a firm o be a leas 13 monhs prior o he merger announcemen. As a resul, 459 mergers are eliminaed due o insufficien IDF coverage of he acquirer firm. Ou of he 2,105 remaining mergers, 135 are eliminaed due o insufficien IDF coverage of he arge firm. The final sample has 1,970 acquisiions, for which insider rading daa for boh acquirer and arge firms is available. 5 Table 2 presens he summary saisics for he merger daa. Acquirers are subsanially bigger han arges and heavily use sock o finance heir mergers as opposed o cash, 49.2% versus 24.3% of he ime. While acquirers earn a negaive announcemen abnormal reurn of -1.3%, acquisiions on average creae value, he average 4-day announcemen abnormal reurn for he 5 When examining he abnormal acquirer insider rading aciviy around he mergers, I use he enire 2,136 mergers for which acquirer insider rading daa is available. For he remaining of he paper, he final sample of 1,970 mergers is used. 8

10 combined firm is 1.2%. Figures 1a and 1b show he annual disribuion of merger aciviy from 1983 hrough The sock-merger wave of he lae 1990s is clearly visible; from 1995 o 2001, no only he majoriy of mergers are sock mergers, bu hese mergers also represen he highes-value deals measured as a percenage of he oal marke capializaion of all public firms in he CRSP daabase. 6 The insider rading daa comes from he IDF daabase, which liss he amoun, ype and dae of each rade as well as he ile of he insider from January 1983 o December To focus on informaion-relaed rades, I analyze he direc open marke sale and purchase ransacions of he managers involving a leas 100 shares. 7 Using he managerial posiion descripions in IDF daabase, I caegorize he managers in o hree disjoin groups ranked in he order of imporance: chief execuive officers (CEOs), direcors of he board and officers. If a person appears in more han one group, I include him only in he one which has he highes ranking. Since I am only ineresed in he managers evaluaion of heir firms, I exclude insiuional shareholders and large individual shareholders who are no managers. Finally I exclude he firms in IDF daabase which could no be mached o CRSP daabase based on he CUSIP code. B. Measuring Misvaluaion My main aim in his paper is o undersand how marke misvaluaion influences merger aciviy. Marke misvaluaion can drive merger aciviy if he managers are opporunisic and ake advanage of he discrepancy beween heir valuaion and marke s valuaion of heir firms. If he acquirer is overvalued, hen he opporunisic managers will ry o use company sock as overvalued acquisiion currency and buy oher firms wih i, before he marke finds ou abou he acquirer s rue value. This is no he only opporunisic behavior riggered by overvaluaion; as long as he managers believe heir firm is overvalued, hey will ry o liquidae heir personal holdings of own company sock a he overvalued marke prices and refrain from buying i on he open marke. This will lead o an increase in managerial sales and a decrease in purchases during 6 For each year from 1983 o 2001, he percenage of oal marke capializaion acquired is calculaed by dividing he oal marke value (measured a 3 days prior o he merger announcemen) of he arge firms acquired in ha year by he oal marke value a he beginning of ha year of all public firms available in he CRSP daabase. 7 Neverheless, I also presen resuls for he value of socks purchased hrough opion exercises from ime o ime for informaion, since mos of he sock sold on he open marke comes from purchases hrough opion exercises. 9

11 he periods when he firm is believed o be overvalued by is managers. As a resul, he managers in overvalued firms will be more likely o be ne sellers han ne buyers in heir firms sock. However, managers can be rading for a variey of reasons like porfolio rebalancing, diversificaion or liquidiy needs. In order o make sure ha he rades I am looking a represen significan changes in holdings raher han marginal porfolio readjusmens, I need o conrol for he wealh of he managers. Since i is impossible o calculae he acual wealh of managers, he bes I can do is o come up wih a reasonable proxy. I use he value of common share holdings as a proxy for wealh. For each ransacion, IDF daabase repors he number of shares held afer ha ransacion. Using his daa, I consruc he number of common shares held a one-year prior o he merger announcemen dae. My measure does no include he value of opion holdings, sock grans or salaries and bonuses, since IDF daabase doesn have his daa. While i is possible o obain daa on he op five paid execuives from Execucomp daabase, doing so would cover only 5% of all he managers in my daa. Since I would like o use he informaion conained in he rades of all managers, no jus he highes ranked ones, I decided o use he common shares held as an imperfec proxy for wealh. I measure he firm-level misvaluaion a he merger dae by calculaing he raio of oal dollar ne purchases (purchases minus sales) by he managers during he one-year period prior o he merger o oal value of heir common sock holdings one year prior o he merger announcemen dae. I name his variable as NET. Negaive values for his variable mean managers as a whole are ne-sellers in company sock whereas posiive values mean hey are ne-buyers. By using he raio of rading o exising sockholdings raher han absolue dollar values, I am able o capure he imporance of he rades relaive o he managers exising common share holdings. I hen classify firms based on he direcion and inensiy of managerial rading using he variable NET. Firms for which NET is less han zero are ne-seller firms, firms wih NET equal o zero are norading firms (NO) and firms wih posiive NET are ne-buyer firms. I hen sor ne-seller firms by he values of NET and label he boom one-hird as high ne-sellers (HS), he middle onehird as medium ne-sellers (MS) and he op hird as low ne-sellers (LS). I label he firms wih no rading (NET=0) as NO. Similarly, I sor ne-buyer firms by he values of NET and label he boom one-hird as low ne-buyers (LB), middle one-hird as medium ne-buyers (MB) and op 10

12 one-hird as high ne-buyers (HB). My final classificaion from highes ne-sellers o highes nebuyers is as follows: HS, MS, LS, NO, LB, MB and HB. If managerial rading aciviy indeed reflecs managers own beliefs abou firm value, hen managers in HS firms will have he highes degree of perceived overvaluaion whereas managers in HB firms will have he highes degree of perceived undervaluaion. Finally I define wo summary groups, oal ne-sellers (TS) and oal ne-buyers (TB) which include HS, MS, LS and LB, MB, HB groups respecively. Table 3a shows he summary saisics for NET across differen rading aciviy caegories 8. During he one-year period prior o he merger, managers in HS firms sell on average 143.7% of heir beginning common share holdings in acquirer firms and 114.6% in arge firms 9. These highly negaive values for NET seem o sugges ha a leas for some firms, here is a serious aemp by managers o abandon sock prior o acquisiions. Wheher or no his represens an abnormal paern of rading will be addressed laer. Table 3b presens he pairwise correlaions of NET variable wih firm characerisics for boh acquirer and arge firms. While mos of he correlaion coefficiens are significan, none of hem is higher han 0.15 in absolue value, and he correlaions ge much smaller if we look a he arges subsample, suggesing ha NET is no proxying for firm characerisics. Correlaions beween NET and oher poenial misvaluaion measures like book-o-price raio (B/P) and pas reurns (RET1 and RET2) are relaively high a 0.14, and respecively for he acquirer firms suggesing ha i is crucial o conrol for hese variables when assessing he srengh of NET in measuring misvaluaion. There are wo main mehodological concerns wih my mehod of measuring misvaluaion. Firs, I mus esablish ha managerial rades are on average informed rades. If he managers are rading due o non-informaional reasons, hen my measure will no capure heir beliefs abou he rue value of he firm. Second, I mus show ha he managers behave opporunisically in heir personal rades and make use of heir insider informaion. Opporunisic managers will decrease 8 There were a oal of 6 observaions where he value of he beginning-of-he-period was very small, resuling in very large posiive or negaive values for NET. To preven his, hose observaions were assigned a NET of 2000% or -2000% depending on he sign. 9 I is possible o have NET smaller han -100% because managers migh purchase sock hrough opions exercises and sell hem on he open marke, driving NET below -100%. 11

13 heir purchases and increase heir sales if hey believe ha heir firm is overvalued. If he managers are opimisic however, hey may expec heir firm s value o increase furher. Therefore hey may increase heir purchases and decrease heir sales. As a resul my misvaluaion measure will incorrecly idenify hese overvalued firms as undervalued. Akbulu (2005a) calculaes cumulaive abnormal reurns for differen even windows following open marke sales and purchases of he managers. Table 4 is replicaed from Akbulu (2005a). Table 4 shows ha purchases are followed by posiive cumulaive abnormal reurns of 0.8% in 5 days o 1.6% in 15 days whereas sales are followed by small posiive reurns. Akbulu (2005a) shows ha here are significan reurn reversals following he sales evens, suggesing ha managers successfully ime heir sales o coincide wih peak sock valuaions. These resuls are qualiaively in line wih he lieraure 10 and sugges ha managerial rades examined in his paper are on average moivaed by managers inside informaion abou he rue value of he firm. In order o see wheher managers on average rade opporunisically, I need o look a he abnormal changes in he managerial rading aciviy around merger announcemens. Opporunisic managers will increase (decrease) heir sales and decrease (increase) heir purchases prior o he announcemen of bad (good) mergers if hey are able o anicipae he value consequences of he merger. Similarly, hey will increase (decrease) heir sales and decrease (increase) heir purchases prior o he announcemen of sock (cash) mergers since using sock (cash) as he mehod of paymen may signal ha he acquirer is overvalued (undervalued). 11 Akbulu (2005a) examines he abnormal managerial insider rading around 2,105 merger announcemens from 1983 o He finds srong evidence for managerial opporunism: managers increase heir sales significanly prior o sock mergers and bad mergers, whereas no such change is observed prior o cash mergers and good mergers, afer conrolling for non-informaional moivaions for rading like porfolio rebalancing, 10 See Jaffe (1974), Finnery (1976), Seyhun (1986, 1998), Rozeff and Zaman (1988), Lin and Howe (1990), Jeng, Merick and Zeckhauser (1999) 11 If managers have more informaion abou he rue value of he firm han he marke, hey will wan o issue new equiy when hey hink ha heir sock is overvalued (Myers and Majluf, 1984). An exensive empirical lieraure shows ha seasoned equiy issues are associaed wih negaive announcemen reurns of abou -3 percen on average (Smih,1986), and he reurns from merger announcemens are abou 3 percen lower when sock is used insead of cash (Andrade e al.,2001). These findings seem o sugges ha overvalued firms prefer sock as a mehod of paymen whereas undervalued firms prefer cash. 12

14 diversificaion and wealh effecs. 12 Table 5 is replicaed from Akbulu (2005a) and i shows regressions of quarerly managerial ne-purchases in dollars and as a percenage of prior holdings on various conrol variables and dummy variables indicaing wheher a given firm is an acquirer or a arge in a good or a bad acquisiion one, wo, hree and four quarers from he curren quarer. The resuls show ha acquirer and arge managers abnormally increase heir ne-sales prior o bad mergers. On he oher hand neiher acquirer nor arge managers exhibi any abnormal increases in ne-purchases prior o good mergers. Finally, acquirer managers in bad mergers sell significanly more in boh dollar and percenage erms han acquirer managers in good mergers. Nex I examine he managerial rading paerns around sock and cash mergers. Table 6-replicaed from Akbulu (2005a)-shows ha boh acquirer and arge managers significanly increase heir sales prior o sock mergers and increase heir purchases prior o cash mergers. Taken ogeher, he evidence from good versus bad and sock versus cash acquisiions sugges ha he managers rade opporunisically in heir personal porfolios around he mergers. Moreover, he evidence from sock versus cash acquisiions seems o be consisen wih a misvaluaion sory where he managers ake advanage of heir privae knowledge abou he value of he firm in heir personal rades. Therefore, examining he managerial rades prior o he mergers gives us a good indicaion of he degree of misvaluaion of he firm. 12 Sock (cash) mergers are hose where he paymen is fully made in sock (cash). Bad and Good mergers are characerized as having a 4-day announcemen cumulaive abnormal reurn of more han less han -10% and more han 10% respecively. 13

15 II. Empirical Tesing of he Marke Misvaluaion Theory of Mergers In his secion I es he empirical predicions of he marke misvaluaion heory by using managerial insider rades in boh acquirer and arge firms as a measure of misvaluaion. A. Acquirer Misvaluaion and Merger Characerisics Table 7 examines wheher here are significan differences in he merger characerisics of acquirers sored by acquirer valuaion levels as measured by managerial rading aciviy. Panel A presens he resuls for all acquisiions, Panel B for sock acquisiions and Panel C for cash acquisiions. Table 7 poins o several imporan differences in he merger characerisics of ne-seller and nebuyer acquirers. Firs, he likelihood of sock paymen increases and he likelihood of cash paymen decreases as acquirer becomes a higher ne-seller: high ne-seller (HS) acquirers use sock as he mehod of paymen 56.9% of he ime whereas high ne-buyer (HB) acquirers use sock 36.4% of he ime. 13 Conversely, high ne-buyer acquirers are more likely o use cash han high ne-seller acquirers. 14 These resuls are consisen wih he marke misvaluaion heory of mergers, which predics ha overvalued firms will prefer o use sock and undervalued firms will use cash as he mehod of paymen in acquisiions. Second, acquirer announcemen abnormal reurns are inversely relaed wih he degree of insider ne-selling. The 4-day announcemen cumulaive abnormal reurn (CAR) is -2.5% for high neseller acquirers compared o a mere -0.2% for high ne-buyer acquirers. Moreover, his difference mosly comes from sock acquisiions where acquirer announcemen CAR is -4.0% for high ne-seller acquirers and -1.4% for high ne-buyer acquirers and he difference is highly significan. This suggess ha he merger announcemen iself causes a parial correcion of preexising acquirer overvaluaion. 13 The difference is 20.5% and significan a he 1% level 14 The difference is 9.1% and significan a he 5%level. 14

16 Third, in cash acquisiions, arge announcemen CAR is higher if he acquirer is a ne-buyer raher han a ne-seller. This reflecs he higher bid premia paid by ne-buyer acquirers, which is 11.9% higher han wha ne-seller acquirers pay. This suggess ha arges are more relucan o accep bids from undervalued acquirers and require higher bid premia, even if he mehod of paymen is cash. As a resul, arge shareholders ge higher announcemen CARs. This is consisen wih Shleifer and Vishny (2003) predicion ha managemen resisance o some cash ender offers is in he ineres of arge shareholders. Fourh, consisen wih he predicion of he Shleifer and Vishny (2003) model, ne-seller acquirers are more likely o make diversifying acquisiions han ne-buyer acquirers. Shleifer and Vishny (2003) argue ha a high valuaion firm migh find acquisiion arges in he same indusry o be very expensive, especially when he whole indusry is overvalued. In his case, making a diversifying acquisiion for sock migh be cheaper for he overvalued firm. Table 7 shows he percenages of diversifying acquisiions compleed for each rading group. Diversificaion is defined as acquirer and arge no having a common 2-digi SIC code in heir firs 6 SIC codes. 13.4% of he acquisiions of ne-seller acquirers are diversifying whereas nebuyer acquirers make diversifying acquisiions 9.7% of he ime. The difference is higher in sock mergers; 11% for ne-seller acquirers and 4.6% for ne-buyer acquirers. On he oher hand here are no significan differences in he percenage of diversifying acquisiions across differen rading levels for cash mergers. The evidence presened so far shows how acquirer insider rading levels are correlaed wih merger characerisics. Nex I presen evidence abou he relaionship beween arge insider rading levels and merger characerisics. B. Targe Misvaluaion and Merger Characerisics Soring acquisiion characerisics by arge insider rading levels in Table 8 reveals significan differences across differen arge rading caegories. Perhaps he mos imporan difference is observed in he mehod of paymen used; high ne-seller arges are much more likely o be acquired for sock han high ne-buyer arges: 55.8% of he high ne-seller arges are acquired 15

17 for sock, compared o 41.1% for high ne-buyer arges. 15 Conversely, high ne-buyer arges are more likely o be acquired for cash han high ne-seller arges. 16 These resuls are consisen wih he predicion of he misvaluaion heory ha acquirers prefer o use sock o buy overvalued arges because his way hey can make he arge shareholders shoulder some of he possible decrease in acquirer sock price resuling from paying oo much for he arge. Two possible explanaions were offered o explain why arge managers should agree o be acquired for overvalued sock. Shleifer and Vishny (2003) assume ha he arge managers have a relaively shor horizon han acquirer managers and hey wan o sell ou for reasons of reiremen or ownership of illiquid sock opions. In his case hey will accep he offer, exchange heir overvalued arge shares for overvalued acquirer shares and sell ou. The marke is assumed o be irraional and herefore does no reac o his exploiaion. Rhodes-Kropf and Vishwanahan (2004) sugges ha he raional arge correcly adjuss bids for overvaluaion, bu when he marke-wide overvaluaion is high, he arge overesimaes he synergies from he merger because i underesimaes he marke-wide misvaluaion and hence acceps he bid. Acquirer announcemen CAR decreases monoonically as he arge firm becomes a higher neseller. Acquirers of high ne-seller arges earn an announcemen CAR of -2.9% compared o - 0.2% for he acquirers of high ne-buyer arges. Once again, his difference is more pronounced in sock mergers; -5.0% for acquirers of high ne-seller arges compared o -0.7% for acquirers of high ne-buyer arges. 17 A possible inerpreaion is ha marke realizes he overvaluaion of he arge a he merger announcemen and conjecures ha he acquirer is likely o be overvalued. Therefore i parially correcs he overvaluaion of he acquirer upon merger announcemen. There is also an indicaion of greaer bid premia for high ne-buyer arges. This is consisen wih he predicions of he Shleifer and Vishny (2003) model, which argues ha undervalued arges will resis he bid unil i reflecs he rue value of he firm, hereby driving he bid premium up. The average bid premium for high ne-buyer arges is a significan 17% higher han ha for high ne-seller arges. This high premium is refleced in arge announcemen CAR 15 The difference is 14.7% and significan a he 1% level 16 The difference is 9.5% and significan a he 5% level 17 Boh differences are significan a he 1% level 16

18 oo; high ne-buyer arges have a significan 4.7% higher average announcemen CAR han high ne-seller arges. However I do no find any evidence of increased probabiliy of hosile bids for he undervalued arges. C. Long-Run Raw Sock Reurns The evidence presened so far seems o be consisen wih he marke misvaluaion sory. Soring he mergers based on prior managerial rading aciviy in acquirers and arges yields significan differences in merger characerisics among firms in which managers are ne-sellers and hose in which managers are ne-buyers. However cenral o my inerpreaion is he correlaion beween managerial rading paerns and misvaluaion. One way of undersanding wheher managerial rades are moivaed by misvaluaion is o look a pre-merger and pos-merger long-run reurns. Marke misvaluaion heory predics ha overvalued firms will have high pre-merger reurns and abnormally high insider sales prior o he merger and negaive long-run reurns afer he merger as he marke gradually correcs he overvaluaion. On he oher hand undervalued firms will have low pre-merger reurns bu high pos-merger reurns. To explore his predicion, pre-merger and pos-merger oal sock reurns are calculaed for acquirers and arges. Toal reurns are calculaed for wo differen periods: he one-year period beween wo years prior o he merger and one year prior o he merger (-2, -1) and he one-year period prior o he merger (-1, ). Table 9a presens he resuls. Table 9a reveals a clear difference in he pre-merger and pos-merger reurns of ne-seller and ne-buyer acquirers, consisen wih he predicions of marke misvaluaion heory. Acquirers wih he highes pre-merger ne-selling also have he highes pre-merger sock reurns and his difference is more dramaic for sock mergers; high ne-seller acquirers in sock mergers have on average 40.1% higher pas sock reurns han high ne-buyers. This paern is compleely reversed afer he merger, wih high ne-seller firms in sock mergers earning a significan 35% lower average pos-merger reurn han high ne-buyer firms in he year following he merger. There is also evidence suggesing ha overvalued arges are acquired mosly by overvalued acquirers: he arges of high ne-seller acquirers earn 19.6% higher pas sock reurns in he year 17

19 before he merger han he arges of high ne-buyer acquirers. Moreover, he resuls from Table 9b -which presens acquirer and arge raw reurns sored by arge insider rading levels- shows ha he acquirers of high ne-seller arges have 20.1% higher pre-merger one-year reurns han he acquirers of high ne-buyer arges. Before drawing any furher conclusions however, I need o make sure ha he observed differences in raw reurns of ne-seller and ne-buyer firms are no jus due o risk facors ha happen o be correlaed wih managerial rading aciviy. In order o conrol for such risk facors, I calculae excess reurns nex. 18

20 D. Long-Run Excess Sock Reurns There is a lo of conroversy surrounding he calculaion of long-run excess reurns in he lieraure. Rier (1991), Barber and Lyon (1997) and Loughran and Vijh (1997) advocae he use of Buy-and Hold Reurns (BHARs) whereas Fama (1998), and Michell and Safford criicize he BHAR approach and advocae Calendar-Time Porfolio Regressions approach (CTPR). Since here is no single perfec measure, I employ boh mehods when calculaing long-run excess reurns. D.1 Buy-and-Hold Abnormal Reurns (BHAR) Firs I calculae buy-and-hold abnormal reurns for he one-year period prior o he merger and he one-year period afer he merger. To calculae excess reurns, each firm is mached o is corresponding 10x10 Fama-French size and book-o-marke porfolio. The maching porfolios, which are consruced a he end of each June, are he inersecions of 10 porfolios formed on size and 10 porfolios formed on he raio of book equiy o marke equiy. The size breakpoins for year are he NYSE marke equiy deciles a he end of June of. BE/ME for June of year is he book equiy in December -1 divided by ME for December of -1. The BE/ME breakpoins are NYSE deciles. The porfolios for July of year o June of +1 include all NYSE, AMEX, and NASDAQ socks wih marke equiy daa for December of -1 and June of, and posiive book equiy daa for -1. The breakpoins and porfolio reurn daa was made available by Kenneh French. Buy-and-hold reurns are measured over monhs -12,-1 for pre-merger reurns and monhs +1, +12 for pos-merger reurns for boh he sample firm and he conrol porfolios, and he difference is recorded as he abnormal buy-and-hold reurn o he sample firm. Table 10a shows he resuls sored by acquirer s managerial rading aciviy. Once again, here is a pronounced difference beween he pre-merger and pos-merger reurn paerns of ne-buyer and ne-seller acquirers, and his difference mainly comes from sock mergers. For example, in sock mergers, acquirers wih he highes insider ne-selling earn a significan 40.3% more pre-merger average BHAR han acquirers wih he highes insider ne-buying. This resul is compleely reversed in pos-merger reurns, his ime high ne-seller acquirers underperform high ne-buyer 19

21 acquirers by as much as 27.1%. 18 Soring BHARs based on arge s insider rading levels yields similar resuls: Table 10b shows ha a high level of insider ne-selling in he arge firm is associaed wih high pre-merger reurns for boh he arge and he acquirer, bu low pos-merger reurns for he acquirer. In sock mergers, acquirers which buy high ne-seller arges ouperform hose which buy high ne-buyer arges by 17.2% prior o he merger, and underperform hem by 10.5% afer he merger. Managerial insider rading aciviy prior o he merger seems o be closely relaed o pre-merger and pos-merger excess sock reurn performance. D.2 Calendar Time Porfolio Regressions Mehod (CTPR) As a nex sep I calculae he long-run excess reurns using he calendar-ime porfolio regression (CTPR) mehod. A every monh from January 1984 o December 2000, calendar ime porfolios are formed by including all he acquiring firms in a given rading aciviy caegory (HS, MS, LS, NO, LB, MB and HB) which announced a merger wih anoher company wihin he previous 12, 24 and 36 monhs. The porfolio is rebalanced every monh o include all he new even companies and o drop off he old ones whose announcemen dae falls ouside of he holding horizon. Boh value-weighed and equally weighed monhly reurns are calculaed for each porfolio and monhly abnormal reurns are calculaed as he inerceps esimaed using boh he Fama-French 3-facor model and he Fama-French-Carhar 4-facor model (Carhar 1997). Heeroskedasiciy is an imporan concern in calendar-ime porfolio regressions; since he composiion of he calendar-ime porfolio changes every monh, resuls from a simple OLS specificaion will be plagued wih heeroskedasiciy. In order o correc his problem, Hou e al. (2001) sugges he following GARCH (1, 1) specificaion: R p 2 R f = α R+ β ( R = α R + ) + β s( RSMB R+ h) + HML s SMB + ε+ h 1 p p p fm p f 2 σ = ω + γ σ σ + = γωε + + γ σγ N+ γ ε p p m f + γ N 3 p p p HML + ε where ε is an independenly and idenically disribued Gaussian random error, Rp is he porfolio reurn, Rf is he one-monh Treasury bill rae, Rm is he value-weighed monhly reurn of CRSP index, SMB is he difference in he reurns of a value weighed porfolio of 18 These resuls are robus o using value weighed reurns insead of equal weighed reurns. 20

22 small socks and big socks, HML is he difference in he reurns of a value-weighed porfolio of high book-o-marke socks and low book-o-marke socks, and he inercep α p represens he average monhly abnormal reurn of he even porfolio. In he second equaion, N is he number of socks included in porfolio a monh and σ 2 is he condiional volailiy of ε. By making he condiional volailiy depend on he number of socks in he calendar ime porfolio each monh heeroskedasiciy problem is alleviaed. I follow he approach of Hou e al. (2001) and esimae he Fama-French 3-facor model using he above specificaion. Fama-French-Carhar 4-facor model is esimaed by adding in he momenum-facor, UMD, o he Fama-French 3-facor model as follows: R p 2 R f σ = ω + γ σ = α + β ( R 1 p 2 1 p + γ 2 ε m 2 1 R f + γ N 3 ) + s p SMB + h p HML + u p UMD + ε UMD measures he difference in he reurns of a value weighed porfolio of wo high prior reurn porfolios minus and he wo low prior reurn porfolios among he six value-weigh porfolios formed on size and prior reurns and was made available by Kenneh French. Tables 11a and 11b presen he esimaes of he α p s which represen he average monhly abnormal reurn of he even porfolio using Fama-French 3-facor and Fama-French-Carhar 4- facor models respecively. I presen he resuls for 12-monh, 24-monh and 36-monh horizons using boh equally weighed and value-weighed reurns sored by acquirer s rading aciviy. Table 11a shows ha high ne-seller acquirers end o underperform high-ne buyer acquirers afer he merger and his effec is sronger in sock mergers. For example for he 12-monh holding horizon and using equally weighed reurns, high ne-seller sock-acquirers underperform high ne-buyer sock-acquirers by a significan 1.58% which ranslaes ino a 19% (1.58*12) underperformance in one year afer he merger. Using value-weighed reurns, he underperformance drops o 1.23% per monh, bu is sill significan. For longer holding horizons, he underperformance weakens because he impac of he even will gradually decline hrough ime and here will be more firms in he porfolio ha had he even long ago. Neverheless, he underperformance of high ne-seller acquirers relaive o high-ne buyer acquirers is sill a 21

23 significan 1.15% per monh for he 24-monh holding horizon using equally-weighed reurns. These resuls are robus o using he Fama-French-Carhar 4-facor model insead of he Fama- French 3-facor model; high ne-seller acquirers in sock mergers significanly underperform high-ne buyer acquirers by 1.47% per monh using equally-weighed reurns and 1.45% using value-weighed reurns for he 12-monh holding horizon (Table 11b). There is also a negaive correlaion beween acquirer long-run abnormal reurns and he degree of ne selling in he arge. Table 11c shows ha in sock mergers, acquirers ha buy ne-seller arges end o underperform hose ha buy ne-buyer arges. The underperformance is 0.6% per monh (which corresponds o 7.2% per year) using he Fama-French 3-facor model wih equal weighs and a 12-monh holding horizon. Similar resuls obain using he Fama-French-Carhar 4-facor model, which are no presened here for breviy. The main conclusion from examining acquirer s calendar-ime porfolio abnormal reurns is ha here is a negaive correlaion beween acquirer s pos-merger long-run abnormal reurns and he degree of insider ne-selling in he acquirer and he arge prior o he merger, and his correlaion is sronger in sock mergers. This confirms he earlier findings obained from raw reurns and buy-and-hold abnormal reurns. Overall, he evidence from raw and excess long-run reurns presened so far is in line wih he predicions of he misvaluaion heory. The mos overvalued acquirers have he highes premerger raw and excess reurns whereas he mos undervalued ones have he lowes. Consisen wih he evenual correcion of misvaluaion, pos-merger raw and excess reurns are lower for overvalued acquirers and higher for undervalued acquirers. These differences are more pronounced in sock mergers, where he overvaluaion is expeced o be more severe. Overvalued arges are more likely o be bough by acquirers wih high pas excess reurns, possibly overvalued acquirers: acquirers buying ne-seller arges have a pre-merger BHAR of -10.3% compared o -0.6% for acquirers buying ne-buyer arges (Table 10b). These findings all poin o he preexising misvaluaion of he acquirers and he evenual correcion of i in he long run. Moreover hese resuls are robus o alernaive mehods of calculaing excess reurns. 22

24 E. Mehod of Paymen Regressions The mos imporan predicions of marke misvaluaion heory involve he mehod of paymen decision in mergers. Therefore I devoe his secion o analyze wheher marke misvaluaion is a deerminan of he mehod of paymen decision. Marin (1996) exensively analyzes he deerminans of he mehod of paymen decision in mergers. He finds ha he higher he acquirer s growh opporuniies, as measured by Tobin s Q, he more likely he acquirer is o use sock o finance an acquisiion. He also finds ha he likelihood of sock financing increases wih higher pre-acquisiion marke and acquiring firm sock reurns and decreases wih higher cash availabiliy, higher insiuional shareholdings and blockholdings and in ender offers. In order o see he effec of misvaluaion on he mehod of paymen decision, I perform mulivariae ess using binary and mulinomial logisic regression 19 models using a variable measuring misvaluaion and variables ha Marin (1996) showed o be imporan deerminans of he mehod of paymen decision. There are four dependen variables. The firs dependen variable represens he decision beween he sock mehod of paymen and cash mehod of paymen, i is equal o 1 if he merger is financed fully wih sock, and equal o 0 if i is financed fully wih cash. The second dependen variable is equal o 1 if he mehod of paymen is mixed (a combinaion of cash and sock) and equal o 0 if he mehod of paymen is cash. The hird dependen variable is equal o 1 if he mehod of paymen is sock and 0 if he mehod of paymen is mixed. The fourh dependen variable akes on 3 possible values; 3 if he mehod of paymen is sock, 2 if mixed and 1 if cash. I measure misvaluaion boh using he coninuous NET variable (which is equal o he value of ne purchases during he one-year period prior o he merger divided by he value of he common-share holdings one year prior o he merger) and using a discree rank variable called 19 In he mulinomial logisic regression, he inerceps are necessary o deermining he probabiliy an acquisiion will be sock-, mixed-, or cash-financed. For example, o deermine he probabiliy of mixed financing as opposed o sock financing, one would subrac he cumulaive disribuion probabiliy of sock financing (compued using he firs inercep) from ha of mixed financing (compued using he second inercep). 23

25 NETRANK, which akes on 7 values: 1 if he firm is a high ne-seller (HS) firm, 2 if he firm is a medium ne-seller (MS) firm, 3 if he firm is a ligh ne-seller (LS) firm, 4 if he firm is a no ne insider aciviy (NO) firm, 5 if he firm is a ligh ne-buyer (LB) firm, 6 if he firm is a medium ne-buyer (NB) firm, and 7 if he firm is a high ne-buyer (HB) firm. By consrucion, for boh NET and NETRANK variables, lower values represen higher levels of overvaluaion. I creae his rank variable for boh acquirer and he arge. Dong e al. (2003) use book o price raio (B/P) of acquirer and arge along wih he raio of residual income model value o price (V/P) as a proxy for measuring overvaluaion. Lower values of B/P represen higher levels of overvaluaion. They find suppor for he marke misvaluaion heory using B/P, namely hey find ha he probabiliy of sock paymen increases as B/P decreases. I include B/P in an alernaive specificaion o see wheher he overvaluaion rank variables sill have explanaory power once an alernaive measure of overvaluaion is included. For each dependen variable, here are wo model specificaions. The firs model is he simples form, i only includes he acquirer and arge misvaluaion variables, diversificaion dummy, log of arge size and log of relaive size and some of he variables ha Marin (1996) showed o be imporan for he mehod of paymen decision, namely acquirer cash holdings, acquirer cash flow and acquirer leverage. In he second model, book o price raios (B/P) and pre-merger one-year reurns and volailiies for he acquirer and he arge are added o he model o make sure ha he misvaluaion variables are no simply proxying for hese variables. Since B/P and Tobin s Q are very closely relaed, I do no esimae a separae model using Tobin s Q insead of B/P as was done by Marin (1996). All regressions include year dummies as well as 2-digi SIC indusry dummies for boh he acquirer and he arge based on he classificaion used by Grinbla and Moskowiz (1999). Table 12a presens he resuls using he coninuous NET variable and Table 12b presens he resuls using he discree NETRANK variable. The mos imporan resul from Table 12a is ha he probabiliy of using sock as a mehod of paymen increases as arge increases is ne-selling. Furhermore, his resul is robus o he inclusion of B/P and pre-merger one year reurn and volailiy of he acquirer, all of which are significan predicors of he sock paymen decision. The coefficien for he Targe NET variable is always negaive and significan in models 1-3 and 7-8. On he oher hand he coefficien of 24