Does long-term performance of mergers match market expectations? Evidence from the US banking industry

Financial Management (Financial Management Association), Summer, 2003 by Gayle DeLong

There is a paradox in bank mergers. On average, bank mergers do not create value, yet they continue to occur. Using cross-sectional analysis to examine 54 bank mergers announced between 1991 and 1995, I test several facets of focus and diversification. Upon announcement, the marker rewards the mergers of partners that focus their geography and activities and earnings streams. Only one of these facets, focusing earnings streams, enhances long-term performance. Two other circumstances improve long-term performance: 1) when a merger involves a relatively inefficient acquirer and 2) when partners reduce bankruptcy costs.

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On average, bank mergers do not create value. A paradox is that they continue to occur. Several studies find that the announcements of bank mergers, on average, neither create, nor destroy stockholder value. Berger, Saunders, Scalise, and Udell (1998) provide an overview of this work. Other studies find that announcements of certain types of bank mergers do create value. Houston, James, and Ryngaert (2001), for example, find the market reacts positively to announcements of mergers that are predicted to reduce costs. This finding is consistent with the results in DeLong (2001), where I indicate mergers that focus along geographic and activity lines--those with the greatest potential for cost savings--create value upon announcement.

I examine here two types of hypotheses that suggest how a bank merger could enhance value. Diversifying hypotheses propose that bank mergers that bring together partners with quite different revenue streams or cost structures will enhance value, while focusing hypotheses describe mergers that bring together similar partners in revenue and cost structures. I examine the market reaction to variables representing these hypotheses and the long-term performance of the acquirer. Focusing mergers are found to enhance value ex ante, but the market correctly identifies upon announcement only one facet that enhances value ex post.

Recognizing the variables that enhance the value of bank mergers both ex ante and ax post is important for several reasons. First, identification of some aspects of mergers that enhance performance helps explain why bank mergers occur, given that they do not enhance firm value on average. Managers promoting a merger can point to a few mergers that do create value as justification for their own attempts. If we can see the elements of bank mergers that do enhance value, we can tell whether such managers are justified. That is, are the mergers that the managers propose in fact similar to the few mergers that create value?

Second, by examining the question in terms of diversifying versus focusing hypotheses, I extend the debate between focus versus diversification into the banking industry. Proponents of the focusing hypothesis such as Lang and Stultz (1994) and Berger and Ofek (1995) contend that firms that concentrate their efforts on limited spheres enhance value, while firms that stray outside their core areas destroy value. Proponents of the diversifying hypothesis assert that firms that obtain cash flows from various sources enhance value, and that concentrating too narrowly on one area is dangerous. (See Stein, 1997; and Hubbard and Palia, 1999).

Third, an understanding of the possible outcomes of a choice of mergers could be useful in evaluating potential merger partners. We could compare this analysis to the use of value-at-risk models to help determine the allocation of risk capital. (See Saita, 1999).

Finally, a comparison of the results of market reaction to the announcements of bank mergers and the long-term performance of the mergers reveals whether the market expectations are realized. Emery and Switzer (1999) show the importance of expected market reaction in structuring takeover bids.

The finding that focusing enhances value agrees with studies that examine conglomerate mergers and the negative effect of diversification in general. Morck, Shleifer, and Vishny (1990) find that returns to bidders are lower when mergers diversify. Lang and Stulz (1994) find a negative relationship between the Tobin's Q of a firm and its level of diversification, and John and Ofek (1995) observe positive stock reactions upon the announcement of focus-increasing divestitures. These researchers, however, look only at unregulated industries--firms that seek to maximize stockholder return and make business decisions in unobstructed environments. If such firms first focus and then choose to diversify, the diversification could stem from non-value-maximizing motives such as an attempt by risk-averse managers to lessen their "employment risk" (See Amihud and Lev, 1981).

Banks, however, could be forced to focus as a result of regulation. (1) Perhaps, for banks, diversification could be beneficial, despite the research that finds value in focusing.

Examination of the banking industry allows for control of possible industry effects as well as tests of bank-specific hypotheses. The role of geographic overlap, for example, is more interesting in service industries like banking than in manufacturing firms since service industries demand proximity to the client.