News reports on corporate mergers, particularly friendly acquisitions which involve a transfer of stock, often take on a familiar form. A company will say it has agreed to take over a rival, and expects that the combined firm will reap bountiful earnings in the first full year after the deal’s completion. It’s such a rosy and reassuring refrain, the sort of sweet tune investors just love to hear. Unfortunately, the lyrics are often let down by reality.
Along with colleagues at Cambridge Judge Business School and the Stern School of Business at New York University, I analysed nearly 500 of the biggest US mergers between 1990 and 2007, and found that forecasts at the time of the deal were regularly over-optimistic. Not only were forecasts well out of line with the pre-merger guidance published by the acquiring company, they often were not matched by actual performance following the transaction.
So how can we explain the tendency towards exaggeration when it comes to post-deal earnings forecasts? Quite simply because it works – in terms of reassuring a firm’s own shareholders that it’s not overpaying, to persuade target shareholders that they’re not receiving overvalued shares, and to attenuate the generally negative market reaction to stock-based acquisitions. Prior studies have shown that the market reacts negatively to announcements of large stock-financed acquisitions and that these acquisitions on average tend to be value destructive in the long run.
Related to this, we found that forecasts subsequently shown to have been over-optimistic have three quantifiable benefits to the acquiring firm. They reduce the premium paid by up to 12 percentage points (compared to an average merger premium of 30% in our sample), speed up merger completion by 41% (compared to a six-month average in our sample), and increase by about 50% the likelihood that a deal will be completed.
This last factor is a crucial one. Prior studies show that there are short-term benefits to all involved parties to complete deals. And our study finds that issuing overly positive forecasts can help to “get the deal done.”
So, putting any ethical debate aside, why don’t managers automatically inflate earnings forecasts when they announce deals? In fact, among the transactions we studied, all of which exceeded $100m and ranked among the 50 largest deals each year, earnings guidance was issued in only 40% of stock-only or mixed stock-and-cash deals, and just 19% of cash-only transactions.
This is because there are clear potential drawbacks in announcing any post-merger earnings guidance. You might tip off potential rival bidders or disclose proprietary information that could help competitors, and introduce a heightened risk of legal action by shareholders who feel they were deliberately misled.
We also found that the benefits of overly cheerful forecasts are enjoyed only by managers whose forecasts in the years prior to the acquisition proved to be credible, and that these managers show somewhat weaker positive bias in post-merger guidance than their less credible peers. So shareholders are not that easily fooled.
However, if managers build up a reputation for keeping on the straight and narrow when presenting routine guidance, investors seem to give them leeway to stray on the positive side when it comes to post-merger guidance. Target shareholders agree to the terms of deal more readily, and acquiring shareholders react more positively to the news. And our study found that whether they knew they were doing it or not, such managers appeared to take advantage of this opportunity – within reason – and thus created the short-term benefits we describe.
Sharing the wealth?
This is all great news for the bidder’s short-term shareholders, who benefit from the immediate share price response; for the bidder’s managers, who succeed in expanding their corporate empire; and for their advisors, whose fees depend on closing transactions. The bereaved, however, are – as so often – long-term shareholders.
Prior evidence shows that these large mergers generally do not deliver the operating improvements they promised. There are often sizeable goodwill write-offs in the years after the acquisition completion, which is essentially an admission that expectations were too high at the time of a deal. They also tend to lead to lower stock returns compared to their peers up to five years following the acquisition.
Shareholders seem to realise the warning signs when the first earnings announcement of the combined firm looms. We find a significant 4% lower risk-adjusted stock return in the two months leading up to that debut earnings announcement of the merged company for those acquirers who went with the most optimistic forecasts, compared to those that did not provide any guidance. So even if optimism can help get a deal done and boost the value in the short-run, markets tend to get their house in order in the end.