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Arranging the Right Corporate Marriage

Anand VijhA new study from the University of Iowa suggests that managers of small firms better protect their shareholders’ stock value by fending off potential acquisitions by larger firms with overpriced stock.

“Small firms are better guardians of their shareholders’ stock value because their managers have incentive and ability to exercise better judgment in choosing acquisition partners and are less receptive to takeovers from firms with overvalued stock,” says Anand Vijh, professor of finance in the Tippie College of Business, who co-authored the study with Ke Yang of Lehigh University.

Research has long shown that many acquisitions come in the form of larger firms with an overvalued stock price buying small firms, using their overpriced stock as an acquisition currency. At the same time, the conventional wisdom has been that the target firm is in most cases significantly smaller than the acquiring firm. Vijh tested that idea by dividing all public firms listed on any of the U.S. exchanges into quartiles based on their market value, and then looking at their acquisitions between 1981 and 2004.

If the conventional wisdom holds, he says firms in the bottom size quartile—typically those below $1 billion in market value—would be the most likely to be either targeted or acquired. However, he found that midsize firms were more likely to be targeted than these small firms. In addition, this pattern was driven by stock deals where only the overvaluation of acquirer stock is a serious concern.

He divided mergers into those where the acquiring firm offered cash and those where the acquiring firm offered its own stock, and found that small target firms were more likely to approve cash takeovers than stock takeovers. The reason, he says, is because the managers at small firms see that an acquiring firm’s stock is overvalued and reject the overture. They are less likely to reject a cash offer because cash cannot be overvalued.

"If the acquiring firm offers $20 per share, $20 is $20,” Vijh says. “But if the acquiring firm is offering a half share of its own stock to shareholders in exchange for a full share, it’s harder to determine the value of that, especially if the acquirer’s stock is overpriced.”

He says small-firm managers are able to exercise this kind of control over the fate of their firm because they are under less shareholder pressure to sell than managers at large firms. Small-firm managers often own a greater share of the company’s stock themselves, and they don’t have to contend with institutional investors or activist shareholders that are more interested in enriching themselves in the short run by selling out to the best offer. That means they can protect shareholder value in ways that large-firm managers can’t.

In addition, Vijh tracked the stock price of acquiring firms for three years after the acquisition and found the price of those companies that acquired small firms performed better than the price of those companies that acquired large firms. The difference was on the order of an extra 20 percent return. He says this evidence suggests the managers of the small firms did a better job of choosing their stock-swap acquirer than the managers of the large firms.

Vijh also compares merger activity during the hot-market years of 1995 to 2000 with the normal-market years of his study period. The late 1990s is well known for widespread irrational exuberance leading to dizzying stock values, and many large firms used this opportunity to acquire small firms with real assets. Vijh finds that during this period, large stock acquirers had proportionately greater success acquiring large targets than small targets, such as Time Warner’s use of its highly inflated stock price as acquisition currency to carry out its doomed purchase of AOL.

As the overvaluations melted in the years after 2000, shareholders of small firms who held onto the stock of the large firms received during a merger would have suffered less of a drop in value than shareholders of a large firm acquired by another large firm.

“This study provides yet another piece of evidence that the shareholders of small firms do better than the shareholders of large firms and attributes it to both better discretion exercised by their managers and their lower appeal to large overpriced stock acquirers that make most of the stock acquisitions,” Vijh says.

The study, “Are Small Firms Less Vulnerable to Overpriced Stock Offers?”, will be published in a forthcoming issue of the Journal of Financial Economics.

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