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
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
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
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
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
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
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
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.