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Investors Put Their Faith in Finance

A new study by a University of Iowa researcher suggests that investors put more faith in venture capitalists and other private financial firms than they do in corporations when it comes to evaluating mergers and acquisitions.

The study, co-authored by Tippie College of Business assistant professor of finance Amrita Nain, found that the stock of companies fares significantly better when they compete with financial investment firms for a takeover target. Performance is even stronger when the financial sponsor makes the first bid and the corporate bidder follows.

“Our results suggest that financial sponsors, such as private equity firms, have superior skills in identifying good takeover targets and negotiating favorable deal terms,” says Nain. “Corporate acquirers can deliver high returns by purchasing targets that financial buyers have already bid on.”

The researchers examined 100,000 successful and unsuccessful mergers and tender offers announced from 1980 to 2007 and classified them into three groups: single bidder; corporate bidder that faced competition from at least one financial sponsor; or corporate bidders competing only with other corporate bidders.

Corporate and financial buyers are typically driven by two different motivations, Nain says. Corporate buyers target firms that will help them expand or consolidate their markets; financial buyers target firms that are undervalued and that can be restructured to increase their value with things like management changes, layoffs, or break-ups.

The researchers tracked the stock price of the corporate bidders in a window that started 20 days before the acquisition bid was announced and ended 180 days later. They found that corporate bidders competing with financial bidders showed a cumulative return of 13 percent during that window, outearning by 8 percent the returns on those companies that didn’t face competition from a financial bidder in their acquisition.

Nain says this drastically improved performance is a likely result of how the market interprets the motivations of the financial bidder. When both a corporate and financial buyer are aiming at the same takeover target, the presence of the financial company sends a signal that the target is undervalued and a good buy. Investors then purchase stock in the corporation involved in the bidding war because it will be a premium acquisition long-term for the company should it acquire the target.

“These results suggest that financial buyers identify good takeover targets, and the winning acquirers reap the benefits,” she says.

The research also showed that corporate stock returns were minimal when the corporate bidder made the first move, but started to rise when a financial sponsor entered the bidding later.

Nain’s paper, “It Pays to Follow the Leader: Acquiring Targets Picked by Private Equity,” was co-authored with Amy Dittmar and Di Li of the University of Michigan. It will be published in a forthcoming issue of the Journal of Financial and Quantitative Analysis.


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