The Source of Gains to Targets and Their Industry Rivals: Evidence Based on Terminated Merger Proposals - Brief Article - Statistical Data Included

Financial Management (Financial Management Association), Winter, 2000 by Aigbe Akhigbe, Stephen F. Borde, Ann Marie Whyte

Ann Marie Whyte [*]

We examine merger gains to targets and their industry rivals and find evidence consistent with the signaling hypothesis. We find that targets and rivals benefit from the merger announcement, but termination results in significant negative returns for targets and significant positive returns for rivals. Termination gains to rivals support the hypothesis that rival firms could become acquisition targets. The gains are positively related to subsequent acquisition activity involving the target and the extent of merger activity in the industry, and are inversely related to the relative size of the target rivals, the presence of competing bidders, and the regulatory environment.

The literature regarding the impact of merger proposals on acquiring and target firms suggests that the shareholders of target firms earn significant positive abnormal returns but the shareholders of acquiring firms earn normal returns. [1] In this study we examine the impact of terminated merger proposals on target firms and their industry rivals. Our study addresses the following empirical question: do merger gains to targets and their industry rivals arise from market power, a signaling effect, or a competitive advantage?

We first examine the intra-industry effects of terminated merger proposals. Previous studies on terminated mergers focus on the valuation effects for target firms. However, if the information conveyed by the merger termination has industry-wide implications, the termination might also result in valuation effects for industry rivals. Second, we extend previous studies that have examined the source of gains from merger proposals such as those by Eckbo (1983), Chatterjee (1986), and Song and Walkling (2000). These studies find that merger gains are the result of a signaling effect and of competitive advantages from combining two firms, but not from the creation of market power. We extend these three hypotheses (market power, signaling, and competitive advantage) to the intra-industry effects of both the merger announcement and the termination. Each hypothesis makes specific predictions for target and rival reaction to the merger announcement and termination. By examining the pattern of abnormal returns for targ ets and rivals across both events, we provide further evidence on the source of merger gains. Finally, we identify the factors that explain the reaction of industry rivals to terminated merger proposals.

We find that both targets and their rivals benefit from the merger announcement. The termination of the merger results in significant negative returns for targets, but rivals experience significant positive returns. Our results support the signaling hypothesis and are inconsistent with the market power and competitive advantage hypotheses. The gains to rivals when a merger is terminated are consistent with the hypothesis that the termination signals an increase in the probability that rival firms will become acquisition targets. The gains to rivals are positively related to subsequent acquisition activity on the part of the target firm and the extent of merger activity in the industry as a whole. The gains are inversely related to the relative size of the target rivals, the presence of competing bidders, and the regulatory environment of the industry.

The paper is organized as follows. Section I provides a brief review of related literature. Section II develops three hypotheses regarding the source of merger gains in detail. Section III describes the sample selection and methodology. Section IV discusses the valuation effects and the cross-sectional analysis, and Section V summarizes the major conclusions of this study.

I. Review of Related Literature

The studies most closely related to our study are those that focus on terminated mergers and on the intra-industry effects of various events. A brief review of the relevant literature follows.

A. Research on Terminated Mergers

Davidson, Dutia, and Cheng (1989) and Sullivan, Jensen, and Hudson (1994) present evidence on terminated merger proposals. Davidson, Dutia, and Cheng find that targets that cancel a merger and later become a party to another merger experience significant positive abnormal returns. Targets that cancel a merger but do not become involved in another merger experience negative abnormal returns when the merger is canceled, and the returns eventually revert to their pre-merger announcement levels. Sullivan, Jensen, and Hudson examine terminated merger proposals and show significantly higher returns for target shareholders when cash is the proposed medium of exchange.

B. Research on Intra-Industry Effects

Several studies present evidence on the intra-industry effects of various events. Slovin, Sushka, and Bendeck (1991) observe significant positive valuation effects for industry rivals of firms involved in going-private transactions. Szewczyk (1992) studies the intra-industry impact of security offerings and finds significant negative abnormal returns to shareholders of rival firms. Slovin, Sushka, and Poloncheck (1992) find similar results for firms in the commercial and investment banking industries. Lang and Stulz (1992) investigate the impact of bankruptcy announcements on rival share prices and observe a 1% average decline in the share prices of rival firms.