Analysis of An Examination of the Long Run Performance of UK Acquiring Firms Paper by Alan Gregory - Coursework Example

Introduction In the 1980s mergers and acquisitions got a lot of publicity because of the high-profile businesses that got involved, all of course, with the ostensible reason to increase value for the shareholder. The 1980s, however, were not the starting point for this business phenomenon and neither did they herald the end for such business relationships. A question that has been of interest to researchers and investors alike has been the extent to which such mergers and acquisitions really add value for shareholders. All along there have been those who claim that many of the promised synergies that are expected to come out of such business relationships never materialize and that sometimes the differences in culture of the businesses involved in the relationship get in the way of achieving the kind of success from which shareholders can profit. In the paper, “An examination of the long run performance of UK acquiring firms,” Alan Gregory examines, from an empirical point of view, when the returns are for a number of UK companies two years following a merger. This paper examines the methodological issues pertaining to Gregory’s research along with the conclusions he draws. 1. Describe 1. What the event is that Alan Gregory examines; The research question that Gregory focuses on is whether acquisitions “led to negative abnormal returns, or whether these results are the result of some type of specification error” (Gregory 1997 971). This question is a potent one. Few companies will go in for an acquisition if they did not have any expectation of increased profitability for the joint business. Abnormal positive returns in such a case would be most welcome because it would have exceeded the expectations of those who made the acquisition or those of analysts and other stakeholders or shareholders. On the other hand, business entails a measure of risk and there is sometimes an expectation that there might be a negative return, at least for a short while, before positive returns kick in. When such a negative return exceeds what is expected and persists for months on end, that is a worrisome scenario for which most cautious business people would take note. Or so one would think. There have been numerous studies that point out that many of the promised positive returns associated with mergers and acquisitions never materialize and that rather than positive returns persistent negative returns are the norm. This is confounding in the sense that even with such information out there for public consumption the mergers and acquisitions mania continues, if on a much lower scale than was the case in the 1980s. Some researchers believe that the persistent negative returns associated with mergers and acquisitions are not right and that there might be an error of misspecification. In other words, it is the methodologies that are being used to measure the returns following the merger that are at issue. In conducting the research, Gregory takes this into consideration but finds no reason to believe that misspecification is at the heart of the matter of the persistent abnormal negative returns in question. 2. What is the period he used; 3. What is the sample and the size of the sample. The period that Gregory focuses on is that between 1984 and 1992 and he focuses on some of the bigger companies, that is, those with assets f more than 10 million pounds. The justification Gregory provides for focusing on such big businesses includes the belief that these businesses not only have greater economic significance. The use of the AMDATA Database for a listing of companies that fit the bill is an appropriate one as this database yields one of the most comprehensive on takeovers in the UK. To ensure that there was consistency in the measures being used, Gregory also ensured that companies that were considered for the study also had in the public domain the LBS Share Price returns and also that, there was information on the market capitalization of the business at the beginning of the year of the takeover. This shows the care with which Gregory took to ensure that apples were being compared with apples. The research focused on abnormal returns of the companies in question over a two year period following takeover. In terms of models that make no use of capitalizations 452 companies came under scrutiny whereas for those for which the Dimson-Marsh criteria were applied, there were 403. 2. Alan says that the portfolio of acquiring companies is biased toward smaller companies. 1. Explain whether this is true; 2. What effect this might have on his study’s result. Though it is the big deals involving businesses of nearly equal size that gets all the attention, Gregory notes that a few companies at the top have very high market capitalization and that these are the companies that are able to afford making acquisitions. In the main, rather than mergers of titans it seems that bigger companies absorb their smaller counterparts in the hope that they will find something in the smaller companies that will increase the overall value and make the takeover worthwhile for the shareholder. It is with this in mind that Gregory points out that “the portfolio of acquiring firms is biased towards smaller companies” (Gregory 1997 977). The really big mergers and acquisitions put the average value of acquisitions at 140.3 million pounds but the median, at 33.6 million pounds, gives a better view of the size of deals that are the most common. If the companies that are being acquired and the deals that are taking place are not all that big one might expect that the hoped for margins, even if positive, might not result in a dramatic increase over the previous earnings of the two companies. It is difficult to imagine that beyond a few savings here and there that a smaller company will so well complement a bigger one that the combined entity will be generating positive returns far in excess of what the market expects. 3. The author references six models in his paper. 1. Describe these models; 2.Explain why he uses all these models; 3. What differences on his estimated parameters are; 4. What are the advantages and disadvantages of these models; 5. Whether these different models give different estimated parameters of abnormal returns. Over the years, a number of models have emerged within the financial community as being robust and rigorous enough in helping researchers to capture various changes in the market place. Gregory focuses on six such models, namely, 1) CAPM, 2) Dimson-Marsh risk and size adjusted model (DM), 3) Simple size control portfolio, 4) Multi-index model using equally-weighted smaller decile minus large decile returns (SML), 5) Value weighted multi-index model using the Hoare-Govett Index as the measure of smaller company performance, and 6) Fama and French (1996) Value-weighted three factor model. The Capital Asset Pricing Model (CAPM) shows the expected return for a particular asset based on three key elements including the pure time value of money, the reward for bearing systematic risk, and the amount of systematic risk. The Dimson-Marsh model is an extension of the CAPM but there is an equal weighting of the average returns on a portfolios of all the companies within which a firm fits. Model 5, in particular, tries to capture the effects or changes in smaller companies and so this is a most appropriate model to include as the vast majority of acquisitions involve relatively small businesses. Likewise, model 4 focuses on companies at the bottom rung of the capitalization scale while Fama and French, model 6 take into account such elements as account size and book-to-market effects. Gregory notes the lack of availability of Book to Market Values for most of the firms in the study, lending survivorship bias to the use of the Fama and French (1996) model. Be that as it may be, the key point is not that one method or model is better than another but that they all capture something of the trend lines in terms of whether a company is doing well or worse over a period of time. Though they are not expected to give exactly the same values, taken together, they can provide insight into the success or lack thereof of the mergers and acquisitions under study. In fact, as Gregory (1997) notes, “None of these models are problem free, but the least problematic would appear to be Model 5…As both Models 4 and 5 use a form of post-event extended CAPM incorporating a small-companies effect, they have the advantage of being compatible with recent papers” (Gregory 1997 982). Gregory is not aware of the problems associated with each of the models, which allows for making the adjustments and interpreting the results based on proper context. 4. According to Gregory's results, explain what the best model is and why. In addressing this issue, prepare a sort of table and use criteria to show how the models affect results. Number Model Advantages Disadvantages 1 CAPM Avoids contamination caused by the tendency of acquiring companies to outperform in the pre-acquisition period No allowance made for firm size effects 2 Dimson-Marsh 3 Simple size control portfolio (SS) Model betas and firm betas are assumed to be identical 4 Multi-index model using equality weighted smaller decile minus large decile returns (SML) Considers bottom 50% of companies by market capitalization Use a form of post-event extended CAPM incorporating a small-companies effect Decile 10 may have thin trading problems 5 Value-weighted multi-index model using the Hoare-Govett Index as the measure of smaller company performance Considers small businesses in terms of market capitalization Considered least problem free Use a form of post-event extended CAPM incorporating a small-companies effect 6 Fama and French (1996) Value-weighted three factor model considers value-weighted returns for both top 30% of companies and bottom 30% Difficulty getting book to market values (BMV) of many firms 5. Give practical analysis of what his data suggests for practitioners, fund manager and investors. These points are all for the skeleton paper and should account for the main part of the report. Even though there are differences among the models used by Gregory (1997) all of the models have been routinely used in finance research because they do measure to a great extent what they purport to measure. It is remarkable also that all the models, despite their differences, point to the same conclusion. As Gregory notes, “Overall, the results from all six models are consistent, with none showing significant abnormal returns for the month of announcement…All models show significant negative APIs and CAARs for the 24 months following completion of takeover. Thus the message from all these event-study models is clear; the long-run shareholder wealth effects of recent acquisitions in the UK have been, on average, significantly negative. However, the various models do lead to economically significant differences in the magnitude of the negative abnormal returns” (Gregory 1997 984). The question has been considered elsewhere that such huge negative figures, rather than reflecting the truth on the ground for the companies involved in acquisitions, might actually be the result of misspecification. In other words, the models that are used to determine whether or not mergers are successful or not has a flow; this is an important point and one worthy of consideration especially when one considers that despite the news and research that point to failure of mergers and acquisitions they remain important to many businesses. If there is a specification error it would explain the anomaly embedded in the contrast between lack of success of mergers and the persistent efforts of companies to enter the mergers and acquisition fray. One research team that challenge various long-horizon tests is S.P. Kothari and Jerold B. Warner, who in the article, “Measuring long-horizon security price performance,” suggests that, The rejection frequencies using parametric tests sometimes exceeds 30% when the significance level of the test is 5%. Our results are robust to many different abnormal-return models. Conclusions from long-horizon studies require extreme caution. Nonparametric and bootstrap tests are likely to reduce misspecification” (Kothari & Warner 1997). Interestingly, Gregory (1997) takes this into consideration and comes to the conclusion that “Given that the central finding of this study is that acquiring firms under-perform, and that this conclusion is obtained using ‘buy and hold’ returns, the consequence is that the significance of the results is likely to be under-stated rather than over-stated. Given the simulation results reported in Kothari and Warner (1997), it is unlikely that the magnitude of the results obtained from a CAR approach, also reported in this paper, can be explained away by specification errors. (Gregory 1997 973) Given what seems almost the last word on the subject by Gregory (1997), namely, that most mergers simply do not work out as planned in terms of sustained profitability, what are the implications for those who find themselves at the helm of companies that are considering making such investments? And what about analysts who must make recommendations of companies that are about to embark on a merger? It is important to note that though many companies fail there are a few that make it. Obviously, any company that is embarking on a merger or acquisition hopes that it will be that exception of success to the rule of failure. Analysts need to be frank in pointing out what the numbers are and in scrutinizing as closely as possible what the purported reasons for expected success might be. As Philippe Hapseslagh notes in an article in the Financial Times, the expected success of mergers and acquisitions often look good on paper. The fact that the reality hardly ever matches the hype, according to Hapseslagh, often stems from forces that “conspire in favour of overpaying, failing to deliver the planned benefits and destroying other value in the process. In this article, I will argue that companies must have a clear acquisition strategy to achieve successful transactions. They also need to present a step-by-step process for clarifying integration trade-offs, to achieve consensus in the acquirer and win the support of managers on both sides” (Hapseslagh 2006). Research indicates that if there are any beneficiaries, quite often they are the sellers, that is, the company that is acquired, and if the price paid for the acquisition is too much it becomes all the more difficult to recoup the investment. Compounding the problem is that sometimes the expected synergies never materialize and culture clashes end up hurting the company and making it difficult to live up to its potential. Synergies are difficult to quantify but it is easy enough to quantify a business and to judge, if somewhat less accurately, whether it is on the path of progress or marching towards a slow demise. As Hapseslagh notes, “Pressures following the acquisition tend to focus attention almost exclusively on the value creation from cost synergies, to the detriment of the less easily quantifiable or tangible benefits that may enhance top-line and capability development” (Hapseslagh 2006). The point here, is not that mergers and acquisitions are bad in themselves but that some of the reasons for which such mergers take place might not be good enough considering that success is often judged almost strictly by the numbers, profitability and growth. Methodology comparison In their 2003 study, “The Really Long-Run Performance of Initial Public Offerings: The Pre-Nasdaq Evidence,” Paul A. Gompers and Josh Lerner take a close look at the five-year performance track of a listing of 3,661 US Initial Public Offerings between 1935 and 1972. The researchers make use of CAPM and Fama-French regressions. The Hoare Govett Smaller Companies index is very well known within the finance research community and the model based on this index, which Gregory uses, provides a nod to Gregory’s understanding of not only the need to capture small company effects but also to choose the proper index in that regard. In terms of the relevance of the models used, there is no question that Gregory (1997) proved to have been on the right track as many of these models are in current use among financial practitioners and researchers. For this reason, prudent managers, analysts, and stakeholders in mergers and acquisitions need to approach any such business couplings with caution and probably much less enthusiasm than has so often been the case in the past. Bibliography Adam, Lewis. “Returns fall flat as Aim index swells.” Fund Strategy, (1/23/2006):9. Gregory, Alan. “An Examination of the Long Run Performance of UK Acquiring Firms.” Journal of Business & Accounting, Vol. 24 Issue 7 (September 1997). Gompers, Paul A. & Lerner, Josh. “The Really Long-Run Performance of Initial Public Offerings: The Pre-Nasdaq Evidence.” Journal of Finance, Vol. 58 Issue 4 (Aug 2003):1355-1392. Hapseslagh, Philippe. “The transaction strategy needs to look beyond expected synergies.” Financial Times, (Oct 13, 2006):6. Healy, Paul M. “Does corporate performance improve after mergers?” Journal of Financial Economics, Vol. 31 (1992):135-175. Read More