The Impact of Finance Mergers and
Acquisitions on Short-Term Performance
of Acquiring Companies
An Event Study Focused on the British Isles
MASTER THESIS WITHIN BUSINESS ADMINISTRATION THESIS WITHIN: Finance
NUMBER OF CREDITS: 15 ECTS
PROGRAMME OF STUDY: International Financial Anaylsis AUTHOR: Kreshnik Elshani
Juan José Ramos Nogales TUTOR: Haoyong Zhou JÖNKÖPING May 2020
Acknowledgements
We would like to thank those who have contributed to the writing of this paper. Firstly, we
acknowledge the help of our thesis tutor Haoyong Zhou, who has helped us with expertise, great
ideas and advice along the way. Secondly, the colleagues Tingxuan Li, Zichun Huang, Eric
Orianwo, and Oliver Frey from the seminars who have provided us with useful feedback. Finally,
we would like to thank Toni Duras for help with using the STATA software and analysing the
code, and Albin Blomberg for the input along the way. Thank you all for your support, without
you this thesis would not have been the same.
________________________ ________________________
Master Thesis in Business Administration
Title:
The Impact of Finance Mergers and Acquisitions on Acquiring Company’s in the
British Isles
Authors:
Kreshnik Elshani and Juan José Ramos Nogales
Tutor:
Haoyong Zhou
Date:
2020-05-22
Key terms: Event Study, Mergers and Acquisitions, Abnormal Returns, Cumulative Abnormal
Returns, Market Model, Finance, British Isles.
Abstract
Background: Mergers and acquisitions (M&A’s) are common ways for businesses to expand,
compete, and maintain in competitive business environments. A strongly debated question in
literature is whether or not these M&A’s provide measurable benefits, as factors such as industry,
geographic location, and regulations play key roles in the impacts of the M&A’s. In this paper, we
investigate the short-term effects of M&A’s based on stock returns of acquiring companies, with
a focus on finance industries in the British Isles.
Purpose: The purpose is to study whether or not there are significant short-term abnormal
returns for acquiring companies when M&As of financial services target enterprises take place.
Further, the study examines factors which can affect the impact of M&A’s, such as size of
transaction, whether it is domestic or cross-border, whether or not the acquiring company is in a
finance industry, and whether there is evidence of merger waves related to finance M&A’s in the
British Isles.
Method: An event study methodology is applied and focused on calculating the cumulative
abnormal returns, as well as verifying whether those are statistically significant. The study analyses
100 M&A’s conducted on target companies from the UK and Ireland between the years 2000
and 2019. The event study is performed using the STATA statistical software, which is used to
analyse the stock return performance in comparison to the domestic market index for each
acquiring company.
Conclusion: The study finds statistically insignificant results, concluding that M&A events do
not generate significant abnormal returns for acquiring companies. This is in line with majority of
previous research done, showing that M&A deals are not deemed significantly value creating nor
value destroying. M&A’s within finance industry where the acquiring companies were domestic,
in a finance industry, where the deals were smaller, were all shown to have less negative, albeit
still insignificant results. This study also presents evidence for merger waves. Moreover, this
thesis adds a clear geographic and industry component which is often missing in previous
research, showing that within finance industry in the British Isles the impacts of M&A deals are
unlikely to be statistically significant in causing abnormal returns.
Contents
1.
Introduction and Background ... 1
1.1
Introduction to M&A’s ... 1
1.2
Background and Information on M&A’s ... 3
2.
Research Problem ... 5
3.
Thesis Purpose ... 5
4.
Delimitations ... 6
5.
Ethical Considerations ... 6
6.
Definitions ... 7
7.
Literature Review ... 8
7.1
Efficient Market Hypothesis... 8
7.2
Event Study Methodology and Abnormal Returns ... 10
7.3
Previous Research on Short-Term Performance After M&A’s ... 12
7.4
Acquisitions: Causes ... 14
7.5
Acquisitions: Consequences ... 15
7.6
British Isles M&A’s - Cross Border versus Domestic M&As ... 16
7.7
Waves in Mergers and Acquisitions ... 18
7.8
Conclusion literature review ... 19
8.
Methodology ... 20
8.1
Data ... 20
8.1.1 Data Gathering ... 20
8.1.2 Research Data ... 20
8.1.3 STATA ... 22
8.2
Event Study Methodology ... 23
8.3
Event Window ... 24
8.4
Estimation Window ... 24
8.5
Normal Returns ... 25
8.6
Abnormal Returns ... 26
8.7
Cumulative Abnormal Returns ... 27
8.8
Tests of Significance ... 27
9.
Empirical Results and Discussions ... 28
9.1
Research Question 1 ... 28
9.2
Research Question 2 ... 31
9.3
Research Question 3 ... 32
9.4
Research Question 4 ... 34
9.5
Research Question 5 ... 35
10.
Conclusions and Discussion ... 36
10.1
Conclusions ... 36
10.2
Discussion... 37
11.
Reference list ... 39
1. Introduction and Background
_____________________________________________________________________________________
In this section we present M&A’s and the current situation M&A activity as well as background. This serves as the introduction to both the thesis topic and thesis focus along with what is aimed to be achieved.
______________________________________________________________________
1.1 Introduction to M&A’s
The worldwide volume of Mergers and Acquisitions (M&A’s) has been increasing lately, and the mergers and acquisitions activity is likely to be driven by companies looking to strengthen their businesses, especially during periods of prolonged uncertainty (Cristerna and Ventresca, 2020). With the multiple benefits possible it is easy to understand why companies seek to combine resources or accumulate as much as they can, but considering the literature there are doubts on whether or not M&As pay off. Depending on different geographic regions and industries, the actual benefits of acquiring other companies can vary significantly (DeYoung, Evanoff and Molyneux, 2009).
There has been significant increase in transformation deals in the United States (+45%). However, there has been a significant decrease in the number of deals in Europe (-27%) and Asia (-29%). When uncertainty arises, companies prefer to stick to the businesses they know very well (related businesses or sector) instead of getting into different markets (Cristerna and Ventresca, 2020), 2020). As uncertainty dampens in 2020, not only are companies expected to gain more strength and liquidity which lead to a more aggressive M&A strategy by the end of 2020, but also this will lead to more M&A activity worldwide (2020 Global M&A Outlook, 2020).
Despite this uncertainty in the markets, 2019 has recorded the third strongest year for global M&A even though they have had a weaker performance compared to 2018 (Data.bloomberglp.com, 2018). The bouncy year in the US was mainly due to the tax cuts and the country’s strong economy. However, 2019 was the lowest in terms of GDP growth since 2008, reporting a roughly 2,5% global growth. While there are many factors which contribute to this result, the predominant effect is the political uncertainty which has spread out across the globe and the trade disputes between major economies are the main causes of the slowdown (Global M&A 2020 Outlook, 2019). There are European countries (excluding the UK, Germany, France, Italy and Spain) where M&As activity is expected to pick up. On the flip side, their interest in the UK remains as fourth
among potential foreign investors even though the uncertainty caused by Brexit (Mergers & Acquisitions Review, 2019).
The UK’s financial sector remains the leading industry in terms of M&As in 2019, accounting for 28% of all transactions which a value of £62bn. Debt funding continues to be accessible and cheap and new bank debt was issued in support of over 511 deals during 2019 by mainly UK and Ireland financial institutions. Aside from major banking groups, new parties have been involved in these debt funding (Experian.co.uk, 2019). The number of M&A projects funded by private equity has significantly increased in the global perspective (Global M&A 2020 Outlook, 2019). Even though it shows a slight down in 2019, this trend is expected to continue in 2020 (Global M&A 2020 Outlook, 2019).
The aim of this research is to analyze the impact of M&A’s of strictly financial services companies which are based in the British Isles. Since “new” finance companies are critical in creating new value in the finance sector, and large companies and funds continue regularly acquiring them in order to gain competitive advantages, it is therefore important to know if those acquisitions pay off according to expectations, and to what extent. Ireland and UK present good research countries as they have a large amount of finance companies, as well as, London being a financial center for the European continent and Dublin becoming a bigger potential financial hub after Brexit (Mergers & Acquisitions Review, 2019).
This paper will focus on recent M&As in the British Isles. More specifically, the impact that a merger or acquisition as an “event” has on the stock prices, and thus returns of the shareholders of the acquiring company. The goal is to contribute to existing research with a focus on finance companies in the British Isles, by researching whether the M&As are profitable in the short-term or not.
The thesis will be relevant for researchers, managers and CEOs. As it contributes with a unique focus in short-term event study research, it provides new knowledge on M&A research focusing on finance industry in the British Isles. Managers and CEOs active in the British Isles can view the results as a guideline for future decision-making in terms of M&A’s. Unlike prior studies which tend to have broader perspectives, this thesis has a narrow focus which provides specific geographic and industry-based results. These results may therefore be regarded as differentiated from other research and suitable for those who are interested in a more detailed and concise report.
1.2 Background and Information on M&A’s
Finance firms have a history of consolidating since the 1980s (DeYoung, Evanoff and Molyneux, 2009), and it is a natural competitive process that could see a future increase as the world becomes more interconnected. The reasoning being similar to that of old family businesses, which used to prevail in every town quarter due to a combination of close relationships with the communities and experience in their areas, nowadays suffering issues with long-term longevity as larger corporations take over (Kuruppuge and Gregar, 2018). In essence, co-operation and inter-connectedness are factors which play a key role in businesses surviving and prospering in today’s business environments, this is what has been the fundamental reasoning behind the merging and acquiring process of companies.
For businesses the benefits and reasons of acquiring another company could be a method of market entry, a way to gain access to tangible and intangible assets and resources, acquiring lower cost processes, lowering competition as well as increasing the market share (Achim, 2015). These plentiful opportunities continue to constitute the main drivers of acquisitions as presented by current research literature. This is especially relevant with new acquisitions due to the notorious rapid technological advancement, which has seen the introduction of the merging between technology and finance. This has increased the demands of many larger corporations who seek to acquire companies with competitive advantages before they become more serious existential threats; primary examples of this are amongst so called fintech companies (Dranev, Frolova, Ochinova, 2019).
The potential for a business to rapidly improve their position on a competitive market through a combination of company capabilities or an acquisition is naturally attractive to business leaders, but it is not without risk. Acquisitions have been shown to be very sensitive to integration processes which can be made difficult by cultural, corporate, and interpersonal reasons (Dranev, Frolova, Ochinova, 2019). Other issues related to M&As are related to technical aspects as well as the underlying motives for the processes. Managers may have what is known in literature as managerial hubris, which causes them to overestimate the benefits of mergers and acquisitions and initiate projects which in turn end up decreasing firm value (Jiang et al., 2011).
Considering both the benefits and the risks, researchers are not in agreement on what the impacts of M&As are on the acquiring firms’ performances, as there is no consistent evidence on whether or not the firms on average benefit from acquisitions (DeYoung, Evanoff and Molyneux, 2009). Hudgins and Seifert (1996) researched stock price reactions of acquisitions within the specific finance section of banking in the US, and found that abnormal returns were not earned by the
acquiring firms, but only by the acquired firms, over the short-term. On the other hand, other researchers found proof of abnormal positive returns in the short-run (Mallikarjunappa, 2018; Rosen, 2006).
DeYoung, Evanoff and Molyneux (2009) further claimed that pre-2000s literature stated that bidder companies (acquiring companies) would face slightly negative returns, while post-2000s literature on the topic stated that acquiring companies could face positive returns as case for European bank mergers. That was not the case for US bank mergers on the other hand which had yielded mixed results (Deyoung, Evanoff & Molyneux, 2009). The mixed results of the impacts of acquisition are also demonstrated in UK government data which shows high fluctuations in amount of acquisitions in recent years.
Although as mentioned earlier there has been a reduction in M&As in Europe overall, which could possibly correlate with the reduction the UK faced in the years post-2008 financial crisis, there has been a dramatic increase since the year 2018. This could be related to recent economic growth in the EU and abroad (Reuters, 2018), as well as a weaker sterling due to the Brexit political process (The In-House-Lawyer, 2020).
Graph 1 – M&A’s of UK Companies by UK Companies Years 2003-2018
Source: Ons.gov.uk, 2020.
The UK rise in M&A’s in 2018 is reflective of the general trend which is similar in Ireland as well (The Irish Times, 2019). The region being examined in the study is therefore highly relevant in terms of M&A activity, and of which impacts we analyze.
0 200 400 600 800 1,000 1,200 2003 2004 2005 2006 2007 2008 2009 2010¹ 2011 2012 2013 2014 2015 2016 2017 2018
2. Research Problem
This thesis will investigate the stock returns of companies which have acquired other firms within the finance industries of banking, asset management and alternative financial investments, in order to empirically research and present whether or not acquiring firms experience abnormal returns in the short-run due to the event of an M&A. Further, to measure whether the returns of those companies post-M&A are positive or negative. If the data shows positive abnormal returns from finance M&A’s, the invisible hand of the market interprets these acquisitions as value creating possibly due to ‘’greater than the sum of parts’’ economies of scale or consolidating market.
The problem is that currently the research literature has been inconclusive, with large variations between studies and depending on industry. It is also difficult to predict if the acquisition will add value to the company in the form of synergies. There has yet to be a specific study focusing on the British Isles and the finance industry connected to it. As there are two international financial centers in the British Isles (London and Dublin) it is an excellent area of studying the impacts of M&A’s due to their clusters of businesses. Thus, both researchers and managers in charge of M&A projects in the region and elsewhere could benefit from this study.
3. Thesis Purpose
The purpose of this thesis is as presented in the introduction to answer the following research questions:
Research Question 1: Are there significant short-term abnormal returns associated with M&As in the finance industry of the British Isles?
Null Hypothesis: There are no significant abnormal returns related to M&A’s in the finance industry in the British Isles.
Research Question 2: Is there a difference in the effects in the short-term between domestic and cross-border M&As within the British Isles finance industry?
Research Question 3: Is there a difference in the nature of the abnormal returns between large deals and small deals of M&As?
Research Question 4: Is there a difference in the nature of the abnormal returns between deals within finance industry companies, and deals where the acquiring company has been of a different industry?
Research Question 5: Is there a presence of merger waves in M&A’s conducted in the finance industry in the British Isles?
Further, we aim to contribute with new research knowledge on mergers and acquisitions with a specific regional and industry focus of British Isles and finance, analyzing whether they are value-creating or not.
4. Delimitations
The scope of this thesis is limited to the geographic areas of Great Britain and Ireland as well as the finance industry. Further, the number of company mergers and acquisitions examined are limited to 100 because of data limitations as they have to qualify a number of criteria such as having stock prices available and having historical stock prices of relevant indexes available. In this study. Due to these limitations, the results should be understood as reflecting the specific geographic and industry areas and may not necessarily be transferable to other areas.
5. Ethical Considerations
Regarding the data gathering for this research, we ensure following of general guidelines provided by Jönköping University on ethical data collection and processing methods. Further, we avoid any form of plagiarism and unethical information-sharing which ensures that our research conclusions become unique related to our research, and have their own implications.
Any implications from the findings of this study regarding the movements of stock prices after acquisitions and the actions based upon it by managers have been considered from an ethical perspective. The agency problems of short-term stock price movements benefitting managers through short term stock-based performance compensation have for the most part been handled internally by the firms through long term stock option incentives and other policies that have been integrated into the firms as historical scandals have shown that short term incentives might hurt the firm and society as a whole.
6. Definitions
M&A
“Mergers and acquisitions (M&A) are defined as consolidation of companies. Differentiating the two terms, Mergers is the combination of two companies to form one, while Acquisitions is one company taken over by the other.” (EduPristine, 2015).
Event Study
Event study is a method of studying how an event changes a firm’s prospects by quantifying the impact of the event on the firm’s stock (MacKinlay, 1997).
Abnormal Returns
Abnormal returns are the difference between the returns that would have been reached if event had not occurred (normal returns), and the actual reached returns. They are calculated by deducting the former from the latter. (MacKinlay, 1997).
CAR CAR refers to Cumulative Abnormal Returns - The sum of all abnormal returns. (MacKinlay, 1997).
Test Statistic
Statistic used to determine if there is a significant difference between the means of two groups, which may be related in certain features (Everitt, 1998).
Null Hypothesis
A general statement or default position that there is nothing significantly different happening, or that there is no relationship between two measured phenomena (Everitt, 1998).
7. Literature Review
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In this section we describe the theoretical framework which underlines this thesis, with specific subsections of relevant theoretical concepts and history in order to get an understanding of the extensive research background which provides a clearer understanding of the thesis topic.
______________________________________________________________________
7.1 Efficient Market Hypothesis
The efficient market hypothesis is a well-supported financial theory which states that in an efficient market the stock prices reflect all available information (Cardona, Gutierrez and Agudelo, 2015). It is a foundation for event studies as it provides the assumption that the market is somehow efficient, which then is the basis of a hypothesis to an analysis of abnormal returns (Collings, Wood and Caliguri, 2016, p. 222-223).
The development of the efficient market hypothesis is generally attributed to Fama (1965), although earlier writers such as Cootner (1964) who claimed that future stock price changes could not be predicted, and Samuelson (1965) who stated that “there is no way of making an expected profit by extrapolating past changes in the future prices”, are also noted as contributing to the original establishment of the theory.
Nevertheless, Eugene Fama in his seminal paper “The Behavior of Stock Market Prices” who not only empirically confirmed the randomness of stock prices by testing the so called “random walk model” (model of assumption that stock prices are followed through a random process), but also defined the concept of an “efficient market”. This was not without elements of critique, as Grossman (1976) claimed that there was a kind of market efficiency paradox, as he stated “informationally efficient price systems aggregate diverse information perfectly, but in doing this the price system eliminates the private incentive for collecting the information”, that is that once traders assume the market is perfectly efficient, they cease to collect information with the same incentive and thus it leads to less efficiency of the market.
Thus, it was already near its conception a theory that did not have full support amongst researchers and academics. Grossman and Stieglitz (1980) further argued that there was a cost of information which made it impossible for the market to be efficient, as informed traders would seek out return on investment higher than cost of information, and the incentive to invest would no longer be there. That was a continuation of the original market efficiency paradox presented by Grossman in 1976. Still in the 1980s, De Bondt and Thaler (1985) conducted research based on both
experimental psychology and studying stock price developments, which found evidence for so called “excess volatility”, that is that people tended to overreact to dramatic or new events, which would oppose the efficient market hypothesis as it could not be explained by publicly available information, or fundamental information, only.
Then came the 90s with Eugene Fama, who also referred to the research done by Grossman and Stieglitz in 1980 when re-presenting the efficient market hypothesis, but with the assumption that cost of information would be zero (Fama, 1991). He presented research on event studies which stated that as early as one day post-announcement of an event, the stock prices would adjust against abnormal returns and thus the market would be efficient. With that said, he also brought up issues with the theory such as event studies, due to focusing on the average adjustment of prices to information, they do not tell how much of the residual variance is rational. Another issue was that event studies had a “joint hypothesis” problem and cannot be tested for market efficiency, as stock prices could react (drift) due to bias in calculating abnormal returns or slow market reactions assuming acquiring firms overpay for their acquisitions (Fama, 1991).
For the purpose of this review it is important to consider the three forms of the efficient market hypothesis which explain how quickly the market would react to publicly announced information which are weak-form, semi-strong-form, and strong-form (Fama, 1965). These three forms are created due to considering the hypothetical information reflected in market prices. Weak-form market efficiency implies that technical analysis of past data would impossibly lead to abnormal positive returns, as the current stock price would reflect all past changes. Weak-form market efficiency has had mixed results in literature with some empirical research proving it (Mobarek and Fiorante, 2014; Alexeev and Tapon, 2011; Chen and Metghalchi, 2012), and other research disproving it (Abushammala, 2011; Ntim et al., 2011).
Strong-form market efficiency implies that stock prices reflect all information, public or not public (Fama, 1965). This is highly unlikely and not supported by literature (Malkiel, 2011). That is as the only realistic way for strong-market-form efficiency to be true is when assuming that insider information is illegal and thus not included in the analysis. Therefore, one can conclude market inefficiencies under this form.
Finally, there is semi-strong-form market efficiency, which implies that only all public information is incorporated into the stock price (Fama, 1965). This form of market efficiency appears to have mixed empirical backing, as Kashiramka and Rao (2014) researched the effects of mergers and acquisitions on stock price returns and found evidence for weak-form market efficiency in the Indian IT sector, but not for semi-strong-form market efficiency. On the other
hand, Jackson (2015) also researched the effects of M&A’s and found significant positive abnormal returns related to the announcement date of an M&A, but since it the total standard abnormal returns returned post-day of announcement date, it was concluded that the market was semi-strong efficient. Research done by Gersdoff and Bacon (2009), also M&A based event study, concluded that one could outperform the market, but found semi-market efficiency in specific days post-event day where stock prices would return towards equilibrium, those days being day 5 and 25.
Despite the criticism towards it, and the research disputing to what degree the hypothesis can be verified, the efficient market hypothesis still serves as a highly relevant research theory with significant empirical support even in new research literature. and which is continuously researched and tested in different settings. It is clear from the research on the topic, going all the way from its academic inception to the current state, that there are critical factors such as geography, industry, scale of research data, and event window periods which play a role in how well one regards the hypothesis to fit reality. In this thesis it will be possible to test the hypothesis through examining the returns related to the event window, which can determine whether acquiring companies outperformed the market or not with the M&A process.
7.2 Event Study Methodology and Abnormal Returns
A common methodology in measuring impacts of certain events is event study, where gains and losses of certain firm events such as M&A’s, corporate announcements, leadership behavior, and other scenarios which are regarded as being able to influence the value of a firm are measured. A key aspect of any event study in finance is the measurement of normal and abnormal returns, which are estimated in order to measure the effect of an event in a certain time period (MacKinlay, 1997).
Beyond the general use of event studies, as has been shown to be extensively used for a large amount of different cases, there is significant use of event studies in specifically M&A research. In fact, event studies are the dominant way of measuring impacts of M&A’s (Collings, Wood and Caliguri, 2016, p. 221-225). The reasons for that are stated as ease of use and precision. With that said, there has also been critique for it being too simplistic, that it fails to include variables such as organizational, social, and market complexities.
The methodology known as an event study originated in 1933 in a paper called "Characteristics and Procedure of Common Stock Split-Ups” by James Dolley, according to MacKinley (1997), but it is widely attributed to either Ball and Brown (1968), who studied the usefulness of accounting income numbers regarding annual reports in estimating stock price returns, or the
well-known paper of Fama et al., (1969), where the researchers measured how quickly stock prices would adjust to new information. More specifically, Fama et al., (1969) researched the effect of a stock split announcement, on the stock prices. They applied the so called “market model” in their event study, where the stock returns were compared to market returns in order to detect abnormal returns. The market model is the most regularly used model for estimating returns in event studies due to it resulting in smaller variances of abnormal returns which leads to greater statistical tests (Strong, 1992), With that said, there are also some other methods for measuring returns in event studies are capital asset pricing model and the mean return model (Cable and Holland, 1999; Fama, 1998).
The importance of understanding event study models is not merely for theoretical purposes, as model misspecification may cause bias in the study (Binder, 1998). This is primarily a problem when relevant variables are omitted or irrelevant are included, but with enough of a sample size and assuming event dates are not clustered in calendar time with the market model the average abnormal returns tend to be unbiased in research studies.
There is discussion on whether market model tends to be the most appropriate, as although some consider it superior to the CAPM model due to doubts on the relationship between beta and stock returns (Cable and Holland, 1999), therefore casting doubts on the CAPM model. Others, like Jagannathan and Wang (1996), defend it by stating that if expanding the market portfolio to include human capital and letting the beta vary over time it performs well in explaining returns. With that said, it is generally accepted that although CAPM and the market model are the main models applied, the market model of event studies dominates the CAPM model in all but a few cases (Cable and Holland). Fama (1998), states that the market model is suitable for estimating the effect of company specific events, such as M&A’s, because the estimation of abnormal returns does not constrain the cross-section of expected returns. This is because expected returns estimated using the market model are conditional because they are given by the market return.
Returning to event studies in general, they have also been criticized by McWilliams and Siegel (1997) when it comes to M&A research for not being enough to explain complex processes such as acquisitions. They argued that accounting measures need to be performed when measuring M&A event impacts. This is on the other hand not fully supported by Collings et al., (2016), who argue that increased measures can cause issues if they do not assess the same theoretical construct. Therefore, based on recent literature which tends to separate the measures in order to more distinctly separate between different measures of gains or losses, for example the difference between profits and abnormal returns, this thesis should focus on one specific measure.
7.3 Previous Research on Short-Term Performance After M&A’s
Measuring the impacts of M&A on stock performance of firms is a relatively common research topic with varying results depending on study method and area. Factors such as whether the acquiring firm or the target firm are analyzed, and which industry is analyzed and during what period are all able to influence the results (Kiymaz and Baker,2008). A key aspect which influences the impact of specifically M&A transactions in the short-term is listed as whether the target company is foreign, while being in the same industry only made a difference in studies with a long-term focus (Hazelkorn et al., 2004).
What research seems to have established is that in most cases, M&A creates value for the shareholders of the acquired firm, but not for the acquiring firm, using stock returns as a measurement for value (Hazelkorn et al., 2004). Although that is disputed by Kiymaz and Baker (2008) who argue that although for the most part the acquiring firm may face negative abnormal returns in the short-term, there are cases of them gaining on it as well, leading to the average benchmark return of M&As being equal to zero. Yuce and Ng (2009), who researched short-term performance of 1361 Canadian M&A without any specific industry target, found that acquiring firms made significant positive cumulative abnormal returns. They did however find that the target firms gained the most from the M&A’s as is stated in most, if not all, of research literature on this topic regardless of geographic location and industry.
A fundamental aspect of just why M&A stock performances for acquiring firms may so often be negative is stated as the “Hubris Hypothesis” (Kiymaz and Baker, 2008; Lin et al., 2008; Raj and Forsyth, 2003). This is the subjective managerial aspect which plays into the decision-making process of an M&A and affects results, and thus research literature. This is important to note as there is not always a quantitative error which by design causes acquiring companies to accumulate negative abnormal returns post-M&A, rather, human faults are consistently brought up as playing a critical role.
With that in mind, Hazelkorn et al., (2004) went on to conduct their own research which showed that in the short-term, the cumulative average abnormal returns were negative for the acquiring company when studying only non-financial industries. Similarly, Kiymaz and Baker (2008) had confirmed the case for non-financial industries, in that stockholders of acquiring firms did not gain as positive abnormal returns (as theirs were negative, if just slightly) as stockholders of acquired firms who got positive abnormal returns.
In the case of firms in finance industry, of which most current literature focuses on banking related industries, literature states that results can vary significantly between the US and Europe. In the
US, most studies find negative abnormal returns associated with acquiring companies, while in the EU there are more studies which point towards positive abnormal returns, at least in the short-term, for acquiring companies (Altunbas and Marqués, 2008). Research done by Cybo-Ottone and Murgia (2000), focusing on the European banking sector, found that there were significant cumulative abnormal returns for both the acquiring firms and acquired firms. The reason for acquiring firms in the EU making positive abnormal returns in the short-term, while not often the case in the US, was stated as regulation differences in the banking sectors (Cybo-Ottone and Murgia, 2000). With that said, it is not necessary that acquiring firms in Europe make positive abnormal returns as more literature shows. Drymbetas and Kyriazopolous (2014) conducted research on 40 European cross-border M&A’s for the period 1998-2009, finding negative abnormal short for the acquiring companies in the banking industry.
Narrowing the focus further down to the British Isles reveals a significant lack in recent literature which focuses on finance and short-term performance of M&A’s. Nevertheless, Uddin and Boateng (2009) analyzed 373 acquisitions in the UK over the period 1994 to 2003 in order to find the impact of M&A on acquiring firms in the short-term. They found that UK firms’ acquisitions did not lead to positive abnormal returns, unless the target company was from the US, which gave support to the idea that geographic locations play a role in the impacts of M&A’s based on stock performance. Similarly, Sudarsanam and Mahate (2003) also found that mergers did not create positive value for acquiring firms’ shareholders when looking at so called “glamour firms” who were highly valued due to past stock performance.
Positive short-term results in the UK were seen by Chinese companies who completed acquisitions of companies in the UK (Zhu and Moeller, 2016). They analyzed a sample of 44 completed M&A using the event study methodology, to find that Chinese cross-border acquiring firms into the UK earned positive abnormal returns on the announcement of an M&A deal. This points towards another key aspect of M&A literature, which is that M&A’s tend to lead to positive abnormal returns to a higher degree when they are Asian companies, or conducted in Asia (Ma et al., 2009). This is theorized as being due to more structured corporate ownership which decreases the risk of M&A related agency problems.
To conclude, there have been lots of studies on the topic of short-term performance after M&A’s. The problem is that there are significant differences in the results depending on geographic region as well as industry, and there is a great lack of literature from the British Isles which focuses on finance industry specifically. As the British Isles are separate from the continental Europe in many cultural aspects as well as in terms of regulations and law as the UK and Ireland use common law, there are aspects which could influence the results of post-M&A performances similar to the claim
for the difference between Asia and Europe. The theory in this case would be based on the difference between the results in China and in Europe, as we would consider if the same kind of law structure differences could apply to differences between Common Law and Civil Law in Europe, and thus also influence the results.
7.4 Acquisitions: Causes
Causes and consequences of M&A have been a topic of discussion for researchers for several decades. Theories which describe the aims for acquisitions sometimes estimates their consequences. Many researchers agree that acquisitions are bundled through time. These clustered acquisitions define the plots of the merger’s activity. Previous studies examined the reasons why mergers occurred. These drivers could be split into 4 groups (Yaghoubi et al., 2016).
Firstly, managers of acquiring companies hoping to generate value to themselves and shareholders due to their overconfidence. Secondly, the decision is driven by industry-level factors, such as industry shocks or size redistribution within an industry. Thirdly, the acquisition is connected with economic conditions and finally the takeover involves behavioral theories (Yaghoubi et al., 2016).
The neoclassical approach advocates that managers undertake acquisitions to maximize shareholders’ wealth. Managers look for value-creating opportunities and possible synergies which could be generated by economies of scale, inefficiency improvements, involving managers on companies’ performance etcetera (Jensen and Ruback,1983).
Non-value adding trades are associated with mistaken decisions. The hypothesis states that overconfident managers have a higher company valuation of the target company and the market does not emulate the full value of the merged company. Moreover, empirical evidence from previous research demonstrates that there are no overall gains from acquisition deals due to managers’ valuation bias (Yaghoubi et al., 2016). This thesis will cover whether or not short-term stock returns reflects the long-term economic evidence.
Contrary to the neoclassical approach, the agency costs hypothesis proposes that managers undertake M&A deals out of self-interest. For example, conflicts over the payout ratio may arise. If the company presents an excess of cash flows and managers decide not to pay dividends, managers might spend this non-profitable cash in value-destroying acquisitions. Handling dividends decreases the resources under management's control, therefore it reduces their power. Preceding research shows that increasing the level of debt compensates the agency cost and as a result, managers wouldn’t have the incentive to take unprofitable acquisitions (Yaghoubi et al.,
2016). Other theories show that managers might tackle conglomerate merger to diversify their portfolio and exposure to the firm. Under this type of acquisition, the target company is completely unrelated, therefore, no synergies are expected. (Amihud and Lev ,1981).
Acquisition activities differ between industries. Previous studies illustrate that M&A might come in waves, which means that if there are industry-level shocks, that would affect the number of acquisitions. This thesis will be focused on the financial services industry in the UK and Ireland. In order to be more precise, we have considered 100 companies and 100 events. Economic industry shocks create discrepancies on company’s valuation causing merger waves altering the individual’s expectations making the future less predictable. In that case, historical data is less reliable to predict future returns, therefore, the number of alternative estimations increase (Yaghoubi et al., 2016). In this study we will complete a deeper analysis of the abnormal returns in order to correct this data misinterpretation.
New technology breakthroughs allow companies to offer new products and services using the latest technology. For example, the acquisition of a Fintech company might change completely how a particular bank processes transactions. The aim of this research is also to analyze the impact of the acquisition of small financial services companies by larger financial institutions. Industry-related acquisitions are considered to be a positive response to industry shocks. Examples of these acquisitions might lead to the emergence of new technologies, innovating financial methods and deregulation.
7.5 Acquisitions: Consequences
The consequences of M&As could be classified into macroeconomic or microeconomic effects. Among the macroeconomic factors, it is obvious that M&As have increased the overall productivity gains, especially in the financial sector industry where companies are highly interdependent. M&A not only transfer and redistribute wealth, they also transfer the know-how and expertise to the acquirer companies. Takeovers are means to increase the capital base of acquiring companies to expand their business and also improves efficiency (Mueller, 1985).
In terms of microeconomic research, M&A have significant consequences in the acquiring company in terms profits, risks growth, leverage and taxes etcetera the thesis will cover mainly the changes in the stocks returns.
Firstly, it might be observed that there are wealth effects on the acquiring firm as target firms do not exist after the acquisitions deal. Previous studies have demonstrated that the announcement of an acquisition causes positive abnormal results for the targeted firm, that’s the reason why
acquirer normally offer premiums to the target company shareholders (Roll, 1986). The synergies achieved can be classified into two types. Operational synergies, such as, distribution and production costs and Financial synergies, such as leverage increase, tax benefits
There is a discrepancy whether abnormal returns are significant or not in terms of the acquirer companies. Some investigations agree to the point that abnormal returns in the short-term as acquirer firms are likely to obtain positive abnormal returns if recent mergers by other firms have been well-accepted or the stock market is performing well. However, there might be a long-term reversal in the acquirers’ returns if the deal was made during the bull market period. (Rosen, 2006). In this research we are going to investigate the impact of these abnormal returns in acquirer firms in the short-term to test this evidence and identify the reasons why M&As in financial keep increasing.
7.6 British Isles M&A’s - Cross Border versus Domestic M&As
As we have previously discussed in the introduction, even though the total value of acquisitions has increased worldwide, the number of transactions has marginally decreased. The global takeovers have slowed this year due to the increase of geopolitical and economic tensions. In this thesis we are going restrict the geographical location to the British Isles (United Kingdom & Republic of Ireland).
In a global sense, firms have multiple motivations as to why they want to conduct an M&A abroad. The possibility to gain from better exchange rates is one example, although investors may be wary of new markets due to different regulatory systems which include different accounting and taxation laws (Rose et al., 2018; Kang 1993). Despite the potential risks, Kang (1993) believed that cross-border M&A’s would lead to higher benefits than domestic M&A’s. This was supported by Goergen and Renneboog (2004) who stated that cross-border operations should be superior according to literature, due to the possibility for acquiring companies to gain from capital and factor imperfections. Ironically, their research results showed that domestic M&A’s resulted in better results compared to cross-border M&A’s.
Further support for domestic M&A’s being generally more positive in their results are given by Eckbo and Thorburn (2000) who researched the gains of acquiring firms from both a cross-border and domestic point of view, and found that domestic M&A’s garnered statistically significant positive results, while cross-border M&A’s would lead to insignificant results. This was supported Rose et al., (2018) and Cybo-Cottone and Murgia (2000), who all argued for domestic M&A’s in favor of cross-border M&A’s, as they would be more value creating and result in higher announcement effects.
Hazelkorn et al. (2004) on the other hand, stated that cross-border M&A’s were more profitable when they researched US companies acquiring other US firms or other firms abroad. This was due to the ability to enhance the geographic coverage, gain access to local technological expertise, acquire lower labor and production costs as well as experience potential for accelerated growth. The idea that cross-border M&A’s are more successful was also supported by Dutta, Saadi, and Zhu (2013), although it is stated that it comes with multiple integration issues as well as a higher complexity.
Regarding the UK, the domestic viewpoint remains unsettled. The UK M&A market has been relatively lower than previous years. A total of 4,998 has been recorded in 2019 which comprises a decline of 12% compared to 2018 (Experian.co.uk, 2019). It might be noticed that the figures are dramatically lower due to the Brexit deadline, for example, just under 1,216 transactions were announced in Q3 almost 700 deals less than Q2. The number of domestic M&As is still remarkably greater than Cross-Border M&As as it happened in the previous years. In terms of allocation London remains by far the main location. In relation to the value (£m), the financial services industry remains as the first sector for M&As (Experian.co.uk, 2019), this is one of the reasons why we have decided to analyze this sector in this report.
Despite Brexit and other geopolitical factors, the outlook for M&A activity in the UK financial services remains positive driven mainly by Fintech innovations. (check data for examples) Long term interest rates keep the cost of debt cheap and central banks are reluctant to increase rates. These factors will continue facilitating to increase the M&As activity (Enterprise Times, 2019)
Financial firms are increasing the number of takeovers of Fintech while it has been noticed a consolidation among mid-sized assets managers and mid-sized brokers largely as result of regulation MiFID II. It is likely that future M&As will be targeted by sub-sectors such as smaller investment banks, asset managers, insurance companies and global payments firms (Enterprise Times, 2019).
Regarding the ROI, economic uncertainty, especially Brexit, has a significant impact reducing the M&A activities. EU buyers are waiting to see the “post- Brexit agreement” in order to complete their takeovers. Companies are looking to Ireland as a post-Brexit European base this is due to the fact that the number of inbound transactions from the UK (including large internal cross-Border transfers) has rocked notably in the financial service sector (The Irish Times, 2019). As the post-Brexit scenario still remains uncertain, it's difficult to predict an M&A forecasting.
Contrary to the UK market, the Irish market presents higher Cross-border than domestic acquisitions (Statista, 2019) Regarding sectors, technology and Pharmaceutical comprised the
higher M&A activity. Financial services industry accounts for approximately 8% (Assets. KPMG, 2019) However, some reports have suggested that this percentage will increase under a positive post-Brexit scenario.
7.7 Waves in Mergers and Acquisitions
As it is known, M&As are one of the most popular business investments. There are some previous studies which state that M&As come in waves as M&A transactions have a significant impact on the market especially in related companies (Institute for Mergers Acquisitions and Alliances IMAA, 2020). A merger wage is an intense period of M&A activities in a particular sector or industry and lasts from a short period to a long period of time depending on the companies involved. The beginning of these waves is not defined but the ending could be related in some cases with political and economic factors (Uddin and Boateng, 2009),for example the 1929 crash or the dotcom bubble. It could be argued that M&As play an important role in market capitalism and there is a continuous wave of M&As: (Institute for Mergers, Acquisitions and Alliances IMAA, 2020).
Based on past experience, it has been illustrated that any M&A wave is triggered by multiple factors. Firstly, all waves happen in periods of economic recovery (following an economic downturn). Secondly, the waves concur with the period of rapid credit expansion, which is the current situation now where interest rates are low and a bullish market period. It might be observed that past waves ended with the collapse of stock markets, as a result, thriving capital markets contribute to waves in M&A.
Thirdly, M&A waves occur before an industrial or technological shock, such as, technology and financial innovations, deregulation, increase of foreign competition etc. M&A deals also increase when regulatory changes related to anti-trust or takeover regulation takes place (Pure.uvt.nl, 2005) In our case, it is obvious that the financial service sector presents waves of takeovers. With London being the financial center in Europe and the thrive of FinTech, acquiring companies are seeking to take over targeted companies which threatens their business model using disruptive technology or revolutionary products in order to remain dominant in the sector.
Previous research suggested that takeovers in the early stages of the wave happens due to industry shocks. These acquisitions tend to generate short-term profits to their shareholders and create synergies. However, unprofitable acquisitions happen due to overvaluations and managers’ overconfidence (Uddin and Boateng, 2009). Finally, it is important to mention that takeover causes differ across M&As waves and sectors.
7.8 Conclusion literature review
The literature on mergers and acquisitions is broad. M&As are among the most important corporate activities with a significant impact on stakeholders. The main findings from previous studies show that: M&A activity presents a wavy pattern (e.g. mergers are clustered in industries through time).
The main factors which cause this fluctuation include industry an economy level shocks, miss-valuation and managerial conflicts. Market response to announcement of acquisition is generally negative for acquirer companies and positive to target companies. Previous research also states several factors related to performance of takeovers, such as, acquirer and target company characteristics, deal offer, industry and macro-environment aspects (Yaghoubi et al., 2016).
We can also conclude that previous studies are heavily biased towards gains to acquirers and elements that affect that earnings. It is also biased in finding sources of value creation of M&As or value-destroying. After multiple studies, the question of what the sources of value in M&As are, has not been answered yet.
8. Methodology
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In this section we describe the methodological approach to this thesis, with descriptions and explanations behind methods chosen. Further, we will also present the data used for the research and how it was gathered. This research is primarily done through the statistical analysis software STATA, and thus much of the methodology explained below is literature based, in order to understand the meaning and reasoning behind the different research steps.
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8.1 Data
8.1.1 Data Gathering
The secondary data for the thesis was gathered using primarily PRIMO university database along with IDEAS Repec. This was done to find the most relevant reviewed papers which could serve as a theoretical foundation for the thesis with scientific background. Google Scholar was also applied. As for finding specific papers we made use of keywords such as “Impacts of M&A’s”, “M&A Short-term effects”, and “Mergers and Acquisitions consequences”, which would then bring us the related literature which could serve as a base to develop upon and find other literature in such a way.
Research papers were chosen for their research significance, relevance to the thesis, as well as date of publishing in order to include the most relevant information available. Papers who are decades old are reviewed due to their status as critical within the topic, which serve as foundations of many other papers and is thus widely regarded as reliable in the more technical aspects of this literature review. Other secondary data was gathered through public publications of companies and firms, as well as government organizations which could provide statistics on M&A’s.
8.1.2
Research Data
The data regarding M&A investigated in this research is exported from the database Thomson Reuter Datastream which is a macroeconomic and financial database that provides reliable and comprehensive data. The observational research complies two separate data sets, the M&As list of events and the daily closing price of target companies from the British Isles (United Kingdom & Republic of Ireland) before and after events from 2000 to 2019. The initial data set exported from Thomson contains 286 observations companies taking part in acquisition.
After filtering the data by announcement date, we gathered a sample population of 100 finance companies and 100 events. Besides making sure that each firm chosen satisfies our selection criteria in terms of sector (alternative financial investments, banks and other financials) and target company’s location. A list of our M&A deals is presented in appendix B.
As has been discussed previously in literature review. The sample has been filtered in order to avoid any possible clash with any other events that could affect the acquiring company’s stocks return. The initial sample extracted from data stream contain 2932 mergers and acquisitions for financial services (defined as Asset management, Alternative Financial Investments and Banks in data stream) in UK and Ireland. Companies with multiple events studies have been remove avoiding noise in the data sample (Aktas, de Bodt and Cousin, 2003).
Acquiring companies which have presented events such as, dividends announcements, annual reports releases, profit warning, changes in the members of the board during the estimation and observation window have been excluded, ending up with a sample of 100 companies with 100 M&As.
To conduct this research, daily closing prices of the following indexes have been exported. Acquiring companies’ stock's returns have been compared according to their benchmark in order to present a foundation for measurement of stock price returns which are then matched to the firm specific stock prices.
Historical stock prices have been extracted from Thomson Reuters Datastream. Only the closing price of the stock has been considered to calculate the stock's returns. The data set is split into 100 target firms and 100 acquiring firms according to their benchmark.
Table 1 - Indexes Used for Generating Market Returns
Acquirer Nation Index
United Kingdom FTSE 100, FTSE 250, FTSE SmallCap
Spain IBEX 35
Denmark OMX Copenhagen 20 United States S&P 500
Canada S&P/TSX 60
Australia AXJO
Switzerland SMI
India Nifty 50
Germany DAX 30
South Africa MSCI South Africa Hong Kong Hang Seng
Qatar QSE
Japan Nikkei 225
Ireland ISEQ
France CAC 40
Norway OMX Oslo 20
Sweden OMX Stockholm 30
8.1.3 STATA
Stata is a statistical software package used for data management, statistical analysis, graphics, simulations, regression and custom programming. Further in this method section we will describe the theoretical aspects of the methods applied, as foundational understanding of the statistical processes involved assists in understanding the results. For the results, we apply the commonly used software tool for event studies which is STATA (Blossfeld et al., 2019).
The code applied will be listed in Appendix C, and is derived from Princeton University’s guide for event studies using STATA. The steps on the program are similar to what would otherwise be done manually on excel, with the benefit that it can more efficiently handle a larger amount of sample data which would otherwise be inefficient in excel.
8.2 Event Study Methodology
This research investigated the effect of an economic event, namely announcement date, using the event study methodology (Arc.hhs.se, 2010). Event studies are created to measure the impact of an economic event on a security’s return. This is one of the most popular methods to measure the impact of M&As on acquiring companies’ stock price therefore, event study method fits to carry out the purpose of this research (Perepeczo, 2007).
The methodology, normally called the abnormal returns methodology, as stated in the literature review is employed to measure the change of stock prices related to certain announcements or events. Resting on the market figures, it might be observed that shareholders benefit from M&As as the stock price tends to rise (Perepeczo, 2007). The purpose of this abnormal return procedure is to define if shareholders’ additional gains or losses depend on the economic event. The abnormal returns quote the excess of returns from a post-acquisition event (Perepeczo, 2007).
Here will be the presentation of the general structure of the methodology, which is followed by more in-depth analysis and argumentation. The event study methodology follows that presented by MacKinlay (1997), which includes 7 steps:
1. Event Definition - We define it in our methodology as the event window, and set it at (-5,+5).
2. Selection Criteria - Our data is restricted to M&A of companies in the finance industry, which is in Thomson Reuters defined as industries Asset Management, Banks, and Alternative Financials. Further, it is also restricted to data availability on the indexes. Indexes used are: FTSE 100, FTSE 250, FTSE SmallCap, CAC 40, S&P/TSX 60, SMI, ISEQ, DAX 30, QSE, Nifty 50, Hang Seng, MSCI South Africa, AXJO, S&P 500, OMX 20, IBEX 35, Nikkei 225, OMX Stockholm 30, OMX Oslo 20.
3. Normal and Abnormal Returns - Measured as the returns of the estimation window and the event window, respectively. Calculated using the market model.
4. Estimation Procedure The estimation window of this event study is 200 days, from -200 days to -20 days prior to the M&A announcement.
5. Testing Procedure - STATA event study procedure following market model structure. 6. Empirical Results - Empirical results will follow the methodology and data sections of
this thesis.
7. Interpretation and Conclusions - Author interpretation of how M&A impact stock prices, and what the effect implies for acquiring firms.
8.3 Event Window
There is no clear literature consensus on what event window to apply and depending on whether it is long-term or short-term studies they can range in research from only the day of the event to over one thousand days post-event. The only technical requirement is that the event window ensures the actual abnormal returns are captured (Sethi and Krishnakumar, 2010). Typical short-term event windows used in literature as 5 or 7 days before and after the event, while long-short-term event windows range from 50 days post-event and beyond (Sethi and Krishnakumar, 2010). Andrade et al., (2001) use a shorter estimate of the average short-term event window at one day before and one day after the event. Further, they state that an event window that is too long reduces the statistical precision of the abnormal returns calculated. Another research benefit is that the shorter the event window the easier it is to identify abnormal returns present (Armitage, 1995). A final argument for using short event windows is stated by Konchitchki and O’Leary (2011), as a short window is less likely to clash with confounding events which also might affect the stock prices.
The event window is the period of the event of interest, in our case it is the period of the announcement dates for the M&As, along with 5 days before, and 5 days after. As there is no strict benchmark on the setting of event windows for short-term analysis, we estimated the period based on earlier research along with literature recommendations in gaining accurate results. Panayides and Gong (2002) consider 5 days a good time period for a short-term event window as it allows one to fully capture the event being examined. It is chosen as (-5,+5) instead of (-1,+1) in order to gain extra data on the returns as well as accounting for a minor error or misplacement in the event date (MacKinlay, 1997). Finally, in this study, the event date, or announcement date, is referred to as day zero as is common in literature (Konchitchki and O’Leary, 2011).
Graph 2. Graphical representation of our event window.
8.4 Estimation Window
Estimation windows refer to a period before the event where the stock returns can be assumed to be normal. They are calculated in order to get a benchmark with which to compare normal and
abnormal returns. The standard procedure is to use a period before the event as the estimation window (Campbell et al., 1997).
Sethi and Krishnakumar (2010) stated that estimation periods are typically a period of 200 days around 250 or 50 days before the event window. We choose to have a period of 220 to 20 in this thesis, as it would be a period completely unrelated to the event period, and thus give us returns which may be assumed to be normal for the company’s without colliding with any other events.
8.5 Normal Returns
The normal returns are the returns we measure which happen during a period before the event window referred to as the estimation window. Its purpose is to give us data of the ordinary returns of the stocks prior to the event. As mentioned in the literature review, there are multiple models to estimate normal returns, such as CAPM, market model, and the mean return model (MacKinlay, 1997). The market model relates the returns of any given security or stock to the return of the market portfolio or index (MacKinlay, 1997), and is by far the most widely used model. For any stock, the estimation of normal returns according to the market model is:
𝑅𝑖𝑡 = 𝛼𝑖+ 𝛽𝑖𝑅𝑚𝑡+ 𝜀𝑖𝑡,
𝐸(𝜀𝑖𝑡= 0) 𝑣𝑎𝑟(𝜀𝑖𝑡) = 𝜎𝜀2
where 𝑅𝑖𝑡 and 𝑅𝑚𝑡 are the period-𝑡 returns on stock 𝑖, and the market portfolio, respectively. 𝜀𝑖𝑡 is the zero mean disturbance term. 𝛼𝑖, 𝛽𝑖 and 𝜎𝜀2 are the parameters (MacKinlay, 1997).
We use the fitting country indexes based on size and industry of companies as the market portfolios with which we compare the stock prices. Since in literature the market model is considered an improvement from other models such as the constant mean return model and the CAPM (MacKinlay 1997; Cable and Holland, 1999), we choose to use it in this thesis.
This is due to the market model being more accurate by removing the part of the returns that is related to variation in the market’s (index) returns, and therefore the variance of the abnormal return is reduced (MacKinlay, 1997). The market model also proved the most successful in a model selection hypothesis testing study conducted by Cable and Holland (1999), as it accounted for the most dependent variables along with being the most accurate. As it can spot abnormal returns more accurately and remove “noise”, it means only the abnormal returns associated with our M&A’s will be highlighted.
Hendersson (1990) states that a majority of event studies use continuously compounded returns, which improve the return distribution normality, eliminating negative values and making it easier to convert daily returns if needed. Thus, the returns are applied in log form as:
𝑅𝑗𝑡= ln(1 + 𝑅𝑒𝑡𝑢𝑟𝑛),
where 𝑅𝑗𝑡 is the continuously compounded return on stock 𝑗 in period 𝑡.
8.6 Abnormal Returns
In order to calculate the abnormal returns, as the event returns may be also affected by external factors (systematic and market risk), it is needed to adjust the returns by subtracting the normal returns. These returns are known as adjusted or abnormal returns (University of Groningen, 2018). The normal return is the expected stock return as if the event didn’t occur. To calculate this expected return, we have taken the stocks prices from the estimation window before the event. It is important to set the estimation window around seven days before the event takes place. The dates from the event window should be excluded as those might be affected by the event in the coming days, otherwise, data might be biased.
In conclusion, the abnormal returns can be calculated following the formula below (Haleblian and Finkelstein, 1999):
𝐴𝑅𝑖𝑡= 𝑅𝑖𝑡− 𝐸(𝑅𝑖𝑡) Where:
𝐴𝑅𝑖𝑡 - Abnormal return for company i over period t.
𝑅𝑖𝑡 – Return for company i over period t.
𝐸(𝑅𝑖𝑡) – Expected return for company i over period t.
t - Day or month, depending on the data accepted for calculations and unit of the event window.
If the abnormal returns 𝐴𝑅𝑖𝑡 is greater than zero, the takeover generates gains for shareholders. When the abnormal returns 𝐴𝑅𝑖𝑡 is equal to zero, the takeover doesn’t affect shareholders’ wealth. However, if abnormal returns 𝐴𝑅𝑖𝑡 is below zero, the takeover makes a loss for shareholders.
