Vol. 4 No. 2 | Fall 2002


A Phenomenon of the Market

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A Phenomenon of the Market

Stock Market-Based Mergers and Acquisitions

Research by Robert W. Vishny

New research explains who acquires whom, whether payment is made in cash or stock, what valuation consequences arise from mergers, and why there are merger waves.

In the late 1990s, the United States and world economies experienced a large wave of mergers and acquisitions, culminating in the bursting of the Internet bubble and the subsequent stock market fallout.

Until now, there have generally been two ways to understand mergers and acquisitions. One explanation relies upon the notion of synergy, i.e. the greater profit potential that results from combining two companies. The second explanation suggests that mergers and acquisitions are the product of bad management being kicked out by better management.

Previous research has addressed the separate merger waves of the past 40 years, offering a different explanation for the waves of the 1960s, '80s, and '90s. A new study, "Stock Market Driven Acquisitions," by Robert W. Vishny, a professor at the University of Chicago Graduate School of Business, and Andrei Shleifer of Harvard University, offers a more unified framework for understanding the different characteristics of acquisitions and how they vary over time.

Vishny and Shleifer suggest that mergers and acquisitions are a financial phenomenon created by stock market misvaluations of the combining firms, and are related to the level of the market as a whole. According to the study, markets are inefficient, while managers of firms are rational, taking advantage of stock market inefficiencies through well-timed merger decisions.

"The objective was to come up with a simpler theory recognizing that valuations differ from true fundamental values temporarily because of market sentiment," says Vishny. "In part, companies make acquisitions or become targets of acquisitions to benefit from stock prices that are temporarily out of whack."

The Spiraling Effect of Misvaluation

A company's valuation may be heavily influenced by investor psychology, since expectations for growth are built into the price investors are willing to pay.

"For example, to justify paying a price-earnings multiple of 150 ($150 per current dollar of earnings), you would have to believe that the company's earnings will grow dramatically over the next five to seven years," says Vishny.

Vishny and Shleifer find that in the 1990s, the valuations for the market were pushed up for some companies much more so than others, creating the "haves" and the "have nots."

Misvaluation in this context refers to the "haves," such as America Online (AOL), Cisco, and Intel, being deemed worthy of excessively high valuations based on unrealistic growth expectations. These companies knew their share price would fall when the market learned of its overconfidence. The star companies therefore had a short-run opportunity to cash in by using their stock as currency to buy other companies-hard assets that were more sanely valued.

"Our model says there was some sanity prevailing among the CEOs of high-flying companies," says Vishny. "They knew that the valuations were unreasonable, so by acquiring all these earnings producing assets in exchange for their shares, they cushioned themselves from the full impact of the bust."

Why would a company agree to be sold in exchange for overpriced stock? The answer can be found in the different "horizons" of corporate managers.

Horizons refer to how long a manager wants to hold onto a company. Managers with short horizons might wish to retire or exit, or simply have options or equity they are anxious to sell. Managers with long horizons might want to keep on working, be locked into their equity, be overconfident about the future, or just love their business.

According to the study, managers with long horizons will make the best of their situation by buying more assets with their high share price while it stays high, fully exploiting their knowledge of market inefficiencies.

In the case of the technology sector in the late 1990s, smaller technology firms were willing to sell to giants such as Cisco and receive overpriced shares as payment, because of their short run horizons and the fact that they could quickly sell the Cisco stock and get access to cash. For these small firms, selling Cisco shares was much easier than trying to sell their own overpriced shares.

The Synergy Story

Mergers and acquisitions rely heavily on the perceived synergy of the combination. According to Vishny and Shleifer, this synergy may simply be a story invented by investment bankers or academics or the market, and have little to do with the reality of what drives acquisitions.

Investors want to see a real reason for the valuation, and therefore aren't satisfied with a company admitting that it is overvalued and using its stock as currency before it crashes, because that will precipitate the crash itself. Vishny notes that it is natural that companies will tell a synergy story even when the real cost-cutting opportunities cannot justify the premium paid.

In some cases, stories for synergy might have some validity; however, in most cases, synergy is played up and is really just a story. The authors suggest that the real reason for an acquisition is usually the different valuations of the target and the acquirer.

In the case of AOL's acquisition of Time-Warner using AOL stock, the authors agree that it is debatable whether there were some synergies, but note that there was also unquestionably a potential valuation motive for wanting the acquisition. In this case, they suggest that the acquisition was an attempt by the management of overvalued AOL to buy hard assets in Time-Warner to avoid even worse long-run returns.

Besides positive perceived synergies, the advantage of acquisitions is that they contribute to the growth of earnings of the firm, and thereby help justify the high valuations.

"Acquisitions were part of the growth strategy of many technology firms in the '90s that helped keep share prices high," says Vishny. "The alternative of simply issuing overvalued shares and parking the proceeds in cash would have quickly burst the valuation bubble of these high-flying companies."


In addition to explaining the nuances of mergers and acquisitions using this new approach, the study offers predictions for when the market is likely to see acquisitions and of what kind.

Acquisitions of undervalued firms are likely to be for cash, and such acquisitions are more likely to be hostile than those for stock. In acquisitions for stock, both the target and the acquirer are likely to be overvalued, with the acquirer being relatively more overvalued. The target management has an incentive to get rid of its shares at a premium, as well as the shares of the acquirer it obtains in the exchange. The target management should welcome the takeover, since it ultimately ends up with cash rather than overpriced securities.

Acquisitions for stock are likely under a combination of three circumstances:
1. Market valuations must be high and there must be supply of highly overvalued firms (bidders) as well as relatively less overvalued ones (targets).
2. The market must perceive a synergy-which both makes the mergers relatively more attractive in the short run and enables acquirers to pay a premium yet still enhance their long run claim on capital.
3. Assuming enough matches to satisfy the first two conditions, there must be some bidders with long horizon managers, and some targets with short horizon managers.

A merger itself can shorten the effective horizon of a manager of a target firm. Without the merger, the manager might be stuck with overvalued shares and options, which cannot be easily sold or exercised. The bidder's shares, on the other hand, can be sold immediately, rescuing the manager from staying long in an overvalued market. The merger therefore can transform a reluctant long-run horizon manager of a target company into a happy short-run horizon manager.

Merger Waves

The final question answered by the study is why mergers cluster in time. It is not simply that many profitable opportunities for combining firms suddenly become available across a range of industries at a point in time, as a synergy explanation would suggest.

The authors argue that each merger wave of the 1960s, '80s, and '90s was related to market valuation. In the conglomerate wave of the '60s, overvalued firms typically bought less overvalued firms for stock. Mergers in the '60s usually involved firms from different industries. In the hostile takeover waves of the 1980s, when valuations were lower, many acquirers were financiers, and the medium of payment was usually cash. Market undervaluation was central to '80s takeovers, since the absolute valuation of some companies was so low that bidders were willing to use real cash to buy them, borrowing via bank loans or newly issued debt in many cases.

Rising stock market prices in the '90s eliminated the undervaluation of the '80s. The merger wave of the '90s is similar to the '60s, since the medium of payment was also typically stock, both occurred during periods of very high stock market valuations, and valuations were very dispersed.

"The truth is that the market can't predict growth rates of companies beyond a year or two," says Vishny. "The valuations that were out there were predicated on a level of overconfidence about the future."

Robert W. Vishny is Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Graduate School of Business.

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