The effect of creditor rights on the relationship of firm-level corporate governance and firm value in case of M&As

Master Thesis

The effect of creditor rights on the relationship of firm-level

corporate governance and firm value in case of M&As

Student Number: S3134741 (University of Groningen) & 901122-T455 (Uppsala University) Name: Mathias Auer, BSc (WU)

Study Program: DD MSc International Financial Management (University of Groningen) & MSc Business and Economics (Uppsala University)

Supervisor: Dr. Victoria Purice Co-Assessor: Prof. dr. Niels Hermes

Abstract:

This study examines the relationship of firm-level corporate governance and firm value, proposing a moderating effect by country-level creditor protection rights in case of M&As. In order to analyse this setting a sample of 331 deals over the period of 14 years (2002-2015) was evaluated. Evidence for a negative relationship of corporate governance and firm value could be found and provides support for the negative spillover theory. Moreover, proof for a negative moderating effect of creditor protection rights is in line with previous literature which suggests that stronger creditor protection rights result in lower risk-taking behaviour which consequently leads to lower firm value. This connection of creditor rights and risk-taking is therefore influencing corporate governance. Furthermore, stronger creditor protection rights are assumed to directly affect firm value. However, no definite conclusion regarding the assumed negative relationship of firm value and creditor protection rights can be drawn since this finding is lacking statistical significance.

Field Keywords: Corporate Governance, Firm Value, Creditor Protection, M&A, Investor

Protection, Agency Conflict

1 Introduction

High occurrence of mergers and acquisitions (M&As) during the last century with the latest rise appearing in the years of 2003 to 2008 and the fact that M&As are considered as crucial drivers for corporate performance have pushed this topic to be among the most investigated ones in the field of international financial management (Hoorn & Hoorn, 2011). Particularly, the area of corporate governance and firm value was extensively investigated as M&As provide the perfect environment to test a change in corporate control and its effect on firm value (Bruner, 2004).

In addition, literature which examines a corporation’s capital structure such as Harris and Raviv (1990) identified several advantages of debt financing over equity financing and nowadays most companies are faced with high dependency on debt financing as an important source of capital which underlines the significance of creditors (Frank & Goyal, 2009). This debt dependency is of essential importance in countries with German legal origin such as Germany, Austria, Japan, Russia and several Eastern European countries (La Porta et al., 1998).

However, research connecting the topic of corporate governance and firm value with creditor rights in case of M&As is limited. Nevertheless, one study in this field, conducted by Acharya et al. (2011) shed new light on it. They examine creditor rights and its relationship to corporate taking in a cross-country investigation. Their results indicate that corporate risk-taking reduces because creditor rights increase the likelihood of managers to undertake diversifying acquisitions which are rather value destroying than creating. Therefore, their study touches upon the agency theory which has a strong association with corporate governance since its mechanisms influence agency conflicts (McColgan, 2001).

The two main agency conflicts found in the literature are according to Eisenhardt (1989), agency conflict type 1, which refers to divergent interests between shareholders (owners) and company executives and the agency conflict type 2, which addresses the conflict of interests between the company’s creditors and shareholders.

According to McColgan (2001), agency problems can be decreased by effective corporate governance mechanisms. Therefore, it can be said that one of the functions of corporate governance is to support shareholders by reaching their aim of enhancing value (shareholder theory). Essential areas of corporate governance are the board of directors, executive management, remuneration schemes, and the legal environment such as shareholder or creditor

protection rights. Moreover, creditors mainly differentiate themselves from shareholders with having a distinct objective. Their aim lies in increasing the probability of receiving payback their provided capital. Another crucial distinction is that creditors have very limited control once the capital is allocated. Thus, the government makes it one of its duties to protect them. Consequently, creditor protection rights are conflicting with corporate governance (Hart, 1995). For instance, the agency conflict type 2 relates to a company’s risk-taking behaviour. Shareholders want their company to take high risks to receive high returns, whereas creditors want a company to take lower risks to secure their cash flow streams and prevent credit default (Wright et al., 1996). Therefore, creditor rights can be seen as a counter-effect on corporate governance.

In contrast, laws to protect equity owners are called shareholder protection rights or investor protection rights. Since shareholders are the owners of the company and therefore have considerable influence on the company’s decision-making process, they also determine agents acting on their behalf (Khan, 2011). These agents should act in the owner’s best interest but this is not always the case which is the root of agency conflicts (Jensen & Meckling, 1976).

Moreover, the article of Acharya et al. (2011) presents interesting insights into the relationship between creditor protection and corporate risk-taking, but neglects the direct relationship with firm value and therefore it is clear that more research in this area needs to be conducted. Furthermore, new insights could be gained if corporate governance will be examined on a firm-level rather than a country-level as previous literature did not investigate this setting and often used investor protection rights (see, e.g., John et al., 2010) or other aspects such as board diversity (see, e.g,. Carter, Simkins, Simpson, 2003) as proxy for corporate governance. In addition, applying a firm-level corporate governance score with emphasis on firm value for equity investors has more practical relevance than using a proxy. Thus, this research tries to find out if stronger creditor rights lead to reduced risk-taking which might lead to lower firm value. The objective is also to find out if creditor rights negatively affect the relationship of corporate governance and firm value. Hence, this study can be seen as explorative.

In contrast, the article of Nini, Smith and Sufi (2012) support the argument of Brockman and Unlu (2009) that creditors have significant power to influence corporate decision-making beyond bankruptcy. Nini et al. (2012) suggest a positive relationship of corporate governance and firm value after a covenant violation.

However, since the positive effect could just be confirmed after a covenant violation it can be concluded that creditor rights might increase the agency conflict and its corresponding

costs which negatively affects firm value. Combining the aforementioned factors, the following broad research questions are formed:

Does creditor protection negatively affect firm value in case of M&As?

Is the influence of creditor protection on the relationship of firm-level corporate governance and firm value in M&As negative as the previous literature suggests?

To answer these question, 331 firm-level observations for a period of 14 years (2002-2015) are collected from Zephyr and Orbis databases. These are supplemented with corporate governance scores from ASSET4 as well as information on returns which were obtained from the Thomson Reuters database.

In order to test the assumptions based on previous literature, three questions were developed. The findings regarding these questions indicate partial support. The first question which assumes a positive relationship of corporate governance and firm value could not be supported since a significant negative relationship was found. The findings of the second question which expects a negative relationship of creditor protection rights and firm value could not be used to draw a conclusion due to a lack of significance. However, the third question which suggests a negative moderating effect of creditor protection rights on the relationship of corporate governance and firm value provides proof of a negative moderating effect.

The remainder of this study is structured as follows: Chapter 2 provides an overview of prior research and the development of the hypotheses. Chapter 3 describes the sample, its distribution, descriptive statistics, the model and its variables. Chapter 4 presents the linear regression results and Chapter 5 has concluding remarks, limitations and possibilities for future research.

2 Literature Review

This section provides an overview of previous and current research conducted in the areas of M&As, corporate governance, creditor protection rights and its connection to firm value. Subsequently, main findings from the literature review will be presented to develop hypotheses, which will then be tested.

2.1 Mergers and Acquisitions

The main reasons for companies to engage in M&As, according to Chatterjee (1986), is for the creation of economic value which is reached through synergies. Value creation through M&As occurs when the value of the combined companies is higher than the added values of the separate companies. In case of M&As, the effect on the shareholder value is often measured by using the cumulative abnormal returns (CAR) (Chatterjee, 1986). In his paper, Chatterjee (1986) mentions three broad classes of synergies: financial, operational and collusive synergies. Financial synergies refer to the cost of capital, operational synergies are associated with production; and collusive synergies address pricing. Firstly, horizontal mergers lead to collusive synergies because the competition decreases and the market share increases, which is motivated by demand-side collusion. Secondly, vertical mergers should lead to operational synergies, which may involve the utilization of economics of scope and/or scale regarding production and distribution, leading to operational synergies, e.g., cost savings. Lastly, conglomerate mergers are often intended as financial synergies since on average larger firms possess superior and more economical access to capital than that of smaller firms (Chatterjee, 1986).

Another meaningful reason for M&As is diversification. DePamphilis (2009) states two commonly used justifications for diversifying M&As. The first one is related to the financial synergies and the second one is related to shifting from the core product lines into markets or product lines with higher growth potential. These new markets or product lines may or may not be related to the company’s current markets or products (DePamphilis, 2009).

In addition to the aforementioned reasons for engaging in M&As, some companies may be motivated by geographic expansion. This argument can be related to operational synergies, economies of scale, and the diversification aspects as companies are as well able to diversify geographically and outside their field of operations. Geographic diversification can be carried out within or outside of a country’s' border, but also across them. M&As involving a bidder

and an acquirer from different home countries are called cross-border M&As (DePamphilis 2009). This type of M&As was frequently examined by previous studies because some of them use investor protection rights (IPR) as a proxy for corporate governance, which changes if there is a change in control, triggered by M&A activity (Martynova & Renneboog, 2008). Therefore, M&As provide the perfect setting for examining a change in corporate governance and its effects on firm value. The reasoning behind this can be explained by the fact that a change in control leads to a change in the target’s legal environment, since the target then falls under the jurisdiction of the acquirer’s home country. Consequently, the target employs the rules of the acquirer’s home country. The same principle can be assumed for corporate governance on a firm-level (Wang & Xie, 2008). Since the change in corporate control is indispensable for the change in corporate governance, a link to the legal perspective regarding M&As will be provided.

The main difference between a merger and an acquisition generally lies in the legal perspective. A merger often leads to a new company formed from two or more companies, which in turn creates a new legal entity from the merging companies. In contrast, an acquisition does not lead to a new legal entity. Consequently, an acquisition involves one firm purchasing another firm (DePamphilis, 2009).

According to Gaughan (2010), M&As can be characterized into three different types: horizontal, vertical, and conglomerate. Horizontal mergers eventuate when two or more companies that have the same market position integrate. Vertical mergers occur when firms with a buyer-seller-relationship come together. A conglomerate merger takes place when the companies do not have either of the two relationships. Regarding acquisitions, DePamphilis (2009) differentiates between friendly and hostile takeovers. A takeover is friendly when the target consents to the acquisition, and it is hostile when the target refuses. In this study, no differentiation between friendly and hostile takeover will be made. However, it will account for diversifying M&As.

2.2 Corporate Governance

During the past decades, corporate governance became interested in the academic field as well as in the daily business life. This might be due to the fact that corporate governance is crucial for a firm’s success, as it deals with the ways through which corporations’ capital providers assure themselves of receiving a return (Shleifer & Vishny, 1997). Therefore,

processes, mechanisms, and relations through which corporations are directed and controlled are key aspects of corporate governance. La Porta et al. (2000) provide a definition with which they explicitly differentiate between company insiders, such as managers and controlling shareholders, and outsiders, such as investors and creditors. Their definition states that corporate governance is mainly comprised of a set of mechanisms that protect outside investors from possible expropriation by company insiders (La Porta et al., 2000).

As corporate governance is such a broad concept and can be affected by numerous different aspects it is difficult to limit the idea behind it to one valid characterization. However, a relatively comprehensive definition was made by Khan (2011) who claims that “Corporate governance is the broad term describing the processes, customs, policies, laws and institutions that direct the organizations and corporations in the way they act, administer and control their operations” (p. 1). The most influential areas in this field of research are board composition, ownership concentration (e.g., controlling blockholders, manager-controlled firms and owner controlled firms), managerial compensation and its monitoring effect on managers and lastly the market for corporate control (M&As and hostile takeovers) (Gupta, Kennedy & Weaver, 2009).

All of these mechanisms comprising corporate governance address the agency conflicts present in modern corporations. The agency theory and its corresponding conflicts were induced by separating control and ownership of companies as discussed by Jensen and Meckling (1976). With respect to firm value these agency problems represent the root of high costs for owners and hence negatively affect the shareholder value. This problem is not only limited to underdeveloped countries but also continues to be a source of high costs for shareholders in advanced countries, which highlights the international aspect of this study (Gompers et al., 2003). Moreover, at this point it is necessary to mention that also alternative theories which explain parts of corporate governance such as the stewardship theory (managers are rational self-interest maximizers), the stakeholder theory (addressing ethical values and morals when managing a firm) and the team production theory (include those in the board of directors who add value) exist (Chambers et al., 2013). Nevertheless, this study has a focus on the agency theory.

According to Eisenhardt (1989), the literature distinguishes between two main agency conflicts. The first one is the conflict of interest between owners and company executives (agency conflict type 1); and the second one is the conflict of interest between owners and the company’s creditors (agency conflict type 2). An example for the agency conflict type 2 is a company’s risk-taking behaviour. Shareholders want their firm to take high risks to receive

high returns, whereas creditors want a company to take lower risks to secure their cash flow streams and prevent credit default (Wright, et al., 1996).

The main methods of solving these agency conflicts are closely related to the aforementioned influential areas of research in corporate governance. The use of the board of directors as a monitoring unit for the senior management, the active market for corporate control and the legal protection of minority investors are the primary methods applied to solve the agency conflicts. Since this study has emphasis on the legal environment also the remainder of this section will especially address legal implications for corporate governance referring to investor protection rights. Moreover, the strength of these methods is dependent on the federal level for securities regulations, on the state level for corporate law and at the firm-level for charter provisions, corporate bylaws, and other rules (Gompers et al., 2003). Therefore, it is important to acknowledge that corporate governance can be seen from different angles. The two most common perspectives used in previous literature are firm-level and country-level corporate governance, which will be used to differentiate when the empirical findings of past literature are stated. However, before the findings of previous studies are going to be discussed, some theories for the relationship of corporate governance and firm value must be presented.

The positive relationship of corporate governance and firm value is closely related to the agency conflict type 1, since it is assumed that the private benefits of corporate insiders affect the investment choices and their respective risk levels. Insiders prefer to utilize corporate resources for their own personal advantage, including the diversion of corporate resources for their self-interest, at the cost of shareholders rather than making optimal choices for shareholders. In addition, the insiders’ behaviour can be compared with that one of senior debtholders because when diverting corporate resources insiders depend on resources before all required cash flow claims can be settled. Particularly, insiders expect to decrease the diversion of corporate cash flows when a corporation’s cash flow is low, since these cash flows lead to fewer resources available for expropriation. Consequently, expropriation activities become easier to detect. At times insiders will even forego risky but firm value enhancing projects to protect their private benefits and just undertake risky projects if the assumed outcome in high cash flow periods is compensating for little diversion in less profitable periods. In addition, investor protection seen as part of corporate governance influences the amount of diverted corporate resources. The better protected investors are, the smaller the expected diversion, which leads to a positive relationship of corporate governance and firm value (John, Litov & Yeung., 2008).

Another argument for a positive relationship is related to managers’ career concerns. In general, managers avoid risks, including value enhancing risks as they might negatively affect their careers, providing a link to the agency conflict type 1. This even leads to managers using corporate resources to engage in value destructing diversifying projects that decrease a company’s operational risk and protect their careers. Consequently, better investor protection as part of a company’s corporate governance leads to more effective monitoring, mitigating this conservative investment behaviour and resulting in higher corporate risk-taking favouring firm-value enhancing projects (John et al., 2008).

A final explanation for the positive relationship between investor protection and corporate risk-taking is built on the impact of non-equity stakeholders such as banks, the government, and labour unions. These influence a firm’s investment strategy within weak investor protection countries. For instance, companies in weak investor protection countries often rely heavily on banks as sources of external financing and therefore they enjoy substantial market power that they use to convince a company to pursue a conservative investment strategy. Consequently, weak investor protection rights as part of a firm’s corporate governance lead to conservative investment behaviour which in turn leads to lower firm value (John et al., 2008).

Nevertheless, theories for a negative relationship of risk-taking and investor protection as part of corporate governance also exist. One theory for such a negative relationship argues that high investor protection environments decrease the concern of shareholders getting expropriated by managers. Therefore, the advantages of dominant shareholders who serve as a monitoring mechanism decrease and the dominance of shareholders decreases, resulting in lower cash flow rights for firms. This enables managers to engage in less risky investments and leads to a negative relationship between corporate risk-taking and investor protection (John et al., 2008).

The following paragraphs will provide empirical insights of research regarding corporate governance at both, country- and firm-level; and its connection to firm value and to the corresponding theories. Studies regarding investor protection are also explored, as numerous scholars use it as a proxy for corporate governance (John et al., 2008; Martynova & Renneboog, 2008).

Gompers et al. (2003) conduct research on firm-level corporate governance and its relationship with firm performance. Their results show that companies with superior shareholder protection rights had stronger revenue growth, higher profits, lower capital expenditures and higher firm value. They developed an investment strategy that buys stock in

firms in the lower section of the index with the strongest shareholder rights and sell stocks of firms in the highest section of the index with the weakest shareholder rights. This investment strategy would have gained 8.5% abnormal returns every year during the whole sample period, indicating a positive relationship between firm value and corporate governance. Since their paper has a focus on equity returns over the whole sample period it examines long-term rather than short-term effects of corporate governance. One of the main obstacles of the paper was to find out if agency costs increase when the shareholder protection rights are weak. Their results provide support for the theories of a positive relationship.

Similar to Gompers et al.’s (2003) approach, Bauer et al. (2004) analyse the influence of firm-level corporate governance on firm value of European companies. Their findings show support for the theories arguing for a positive relationship. However, the positive relationship is substantially weakened when adjustments for country specific differences were made, emphasizing the international aspect and country differences. Additionally, significant differences between firms from the UK and from rest of Europe were found. For instance, the study did not find any evidence for a relationship between corporate governance and firm value in the UK. This is an indication that UK markets might have been still adjusting because in the long-run excess returns of good corporate governance should lead to higher firm value. In the European Monetary Union (EMU), excess returns of the corporate governance strategy were substantially smaller. This might indicate that current corporate governance standards were largely incorporated into stock prices. A justification for investors in EMU companies already more accounting for a company’s governance standards than investors in UK companies might be the fact that Eurozone companies often tend to have poorer corporate governance standards. Moreover, this study was able to show that lower corporate governance standards of firms lead to a stronger relationship with firm value. Meaning that the relationship of corporate governance and firm value loses importance when a company’s corporate governance is high. In contrast to Gompers et al. (2003), the study of Bauer et al. (2004) find a negative relationship between governance standards and earnings-based ratios for performance.

Drobetz, Schillhofer and Zimmermann (2004) apply another comparable approach to Gompers et al.’s (2003) study. They implemented an investment strategy that buys high corporate governance firms and short sells low corporate government firms, consequently earning abnormal returns of approximately 12% annually throughout the whole sample period. They concluded that firm-level differences in the quality of corporate governance facilitate explaining firm performance within a jurisdiction. In addition, they report a positive relationship between corporate governance practices and firm value. However, they also

provide support for a negative correlation between expected stock returns and firm-level corporate governance when dividend yields were used as a proxy for the cost of capital.

Furthermore, John et al. (2008) find that stronger investor protection (on country-level) as part of a company’s corporate governance leads to higher risk-taking, which leads to higher firm value, supporting the theory of a positive relationship. The article argues that investor protection decreases the possibility of company executives of taking private benefits, leading to them pursing in excess risk-avoiding activities. Additionally, John et al. (2008) suggest that in strong investor protection environments a firm’s stakeholders (e.g., creditors, the government and labour groups) are not able to effectively reduce its risk appetite for their self-interest. Thus, supporting the third explanation for a positive relationship.

As this study examines the relationship of corporate governance and firm value in the case of M&As it is crucial to point out how M&As interfere with this relationship. An essential aspect for this study is the change of control deriving from M&As, in which the acquiring company attains a controlling stake in the target company. Most of the previous studies addressing corporate governance and firm value in the case of M&As are limited to cross-border M&As, as a change of control of the target company results in a change of its legal environment when it becomes part of the bidder’s home country jurisdiction. Therefore, country-level corporate governance changes due to a change in national corporate governance standards (Martynova & Renneboog, 2008).

However, the change of a firm’s corporate governance is not only limited to a change of its legal jurisdiction, as is the case in cross-border M&As. Therefore, a change of the target’s firm-level corporate governance takes place with a change of control in domestic M&As as well (Wang & Xie, 2008).

The general theory related to the change of corporate control in the case of M&As argues that if target firms with weak corporate governance are acquired by bidders with strong corporate governance, it leads to higher total gains. Part of these gains, also called synergies, may derive from the enhancement of the target’s corporate governance and assets under its restriction (Wang & Xie, 2008).

Previous literature identifies three spillover theories: the positive spillover by law, the spillover by control, and the negative spillover by law theory. For the positive spillover by law theory, it is argued that in complete takeovers, the corporate governance of the bidder is imposed on the target. This in turn is expected to result in value creation, since a change to better corporate governance should lead to an increased emphasis on shareholder value as agency costs reduce. This is caused by a reduction of managerial private benefits of control.

The spillover by control theory reasons that in partial takeovers the improvement of the target’s corporate governance might materialize on a voluntary basis. Therefore, part of the value creation can be justified if the company from an acquiring country has stronger shareholder rights than the target. For the negative spillover by law theory, it is argued that the takeover gains will decrease if the corporate governance of the acquirer is lower than the corporate governance of the target. Therefore, worse corporate governance of the acquirer relatively to the target’s corporate governance leads to value destruction and negative returns (Martynova & Renneboog, 2008).

Wang and Xie (2008) found evidence for advantages arising from a change in control in the case of M&As. Their results show that stronger shareholder rights of the acquirer seen in relation to the target’s shareholder rights, create higher synergies. The reasoning behind this finding is that a change in control will lead to an improvement of the target’s corporate governance and therefore these acquisitions create more value because the assets of the target will be used more effectively. As a consequence, their findings support the positive spillover theory. In addition, they point out that the synergies created by corporate governance are divided between the acquirer and the target stockholder, as acquirer and target returns increase with the difference of the shareholder rights between the acquiring and the target firm (Wang & Xie, 2008).

Martynova and Renneboog (2008) examined corporate governance and takeover returns in the cases of cross-border M&As. They constructed a country-level corporate governance index which includes shareholder, minority shareholder, and creditor protection in order to find out if bidder and target corporate governance significantly impacts takeover returns. They argue that if the bidder stems from a country with strong shareholderorientation compared to the target, part of the synergies created may derive from the improvement of the utilization of the target’s assets, as corporate governance enhances. Regarding their empirical findings, they provide support for the positive spillover by law and the spillover by control theory. However, the negative spillover theory could not be confirmed.

Another article regarding corporate governance and firm value was written by Starks and Wei (2013). This study examines the relationship of (country-level) corporate governance and firm value in the case of cross-border M&As. Their findings suggest that shareholders of the acquiring firm need to compensate shareholders of the target firm with higher premiums for bringing them worse corporate governance systems in cases where the method of payment was stocks. This can be concluded since the takeover premiums decrease with the quality of the country-level corporate governance of the foreign acquirer when the deal’s method of payment

was stocks. Meaning that the acquiring company pays lower premiums if their country’s corporate governance is high for deals settled in stock. Moreover, their study indicates that takeover premiums reduce with the acquiring firm’s shareholder protection rights and corporate governance when the payment was done by stocks. In addition, the abnormal returns of the acquirer’s shareholders increase with the corporate governance level of the home country. Nonetheless, they state that due to endogeneity between corporate governance and firm value it is tough to reach a definite conclusion if corporate governance has any effect on firm value.

Furthermore, a study examining the legal environment in which a company operates and its relationship with firm value in the case of cross-border M&As was written by Bris and Cabolis (2008). They find that better investor protection and better accounting standards as part of the acquirer’s corporate governance result in higher bid premiums in the case of cross-border M&As, providing further proof of a positive relationship.

Based on the findings of previous literature, generally pointing towards a positive connection of corporate governance and firm value in very different scenarios, this positive relationship is also expected to be the main relationship of this study in the case of M&As. Therefore, the first hypothesis is formulated as follows:

H1: There is a positive relationship between corporate governance and firm value in the case of M&As.

Apart from the corporate governance discussed above, creditor protection rights is another concept aimed at the agency conflict type 2 and also affects firm value. Due to the fact that corporate governance can be seen as a construct of mechanisms by which outside investors are protected against expropriation by company insiders, it is clear that creditor protection is part of the broad concept of corporate governance (La Porta et al., 2000). However, most of the studies do not include creditor protection in their measurement of corporate governance, as they solely focus on equity providers and their relationship with corporate governance and shareholder value rather than focusing on debt providers. Another reason for the missing incorporation of creditor protection in corporate governance is that most previous studies use one component of corporate governance as a proxy for the overall concept of corporate governance, for example the study of Carter, et al. (2003). Additionally, previous literature argues that the creditors’ influence on corporate decision-making outside of bankruptcy situations is limited. Nevertheless, growing literature such as Brockman and Unlu (2009) and

Nini et al. (2012) contrast this statement and argue that even outside of bankruptcy creditors are able to exert significant power on corporate decision-making. Therefore, the next part is going to take a closer look at what creditor rights are, how they impact firm value and lastly, how they might moderate the relationship of corporate governance and firm value in the case of M&As.

2.3 Creditor Protection Rights

In principle, creditor protection rights are legal provisions established to protect the lender’s ability to collect their outstanding debt. Creditors refer to these crucial laws in reorganization and liquidation procedures, as they determine the property rights of a bankrupt corporation and by whom the insolvency process is managed. (Bae & Goyal, 2009). Moreover, to the effect that creditor protection rights can be referred to as a penalty in the event of a default seen from the debtor’s perspective since this penalty aspect of debt financing increases the incentive of managers to avoid default. Therefore, creditor protection rights better align the interest of company insiders, shareholders and creditors. Consequently, creditor rights also function as a monitoring mechanism for company insiders (Hart, 1995).

When placing creditor protection rights in contrast to investor protection rights, it is important to mention La Porta et. al. (1998) who state that creditor protection rights are more complex than investor protection rights because they require other rights to be reduced in order to function properly. La Porta et. al. (1998) refer with “complexity” to two main aspects:

The first one is that there are several different types of creditors all requiring different protection rights due to their different interests. As a result, these different protection rights might conflict when superior protection rights for one group can lead to inferior protection rights for another group. For instance, if a company defaults junior unsecured debt holders have an interest in keeping the company alive since they might regain some parts of their money in case the company will make profits again. In contrast, senior secured debt holders might just want to receive possession of the collateral and are not concerned with what might happen to the company (La Porta et al., 1998).

The second aspect lies within the two mechanisms in place to deal with a company’s default. These two mechanisms, reorganization and liquidation, require different rights in order to be effective. The mechanisms are reorganization and liquidation. Senior collateralized creditors can be seen as creditors with the most basic rights, namely the right to repossess

collateral if the credit is in default. In that case, the repossessed collateral can be kept or liquidized. An issue regarding the repossession arises in countries where laws make it difficult to repossess collateral. This is due to the fact that repossession leads to a company’s liquidation, which is not desirable for a society. Regarding that issue, the question, if both mechanisms are required arises, since a country with a flawless liquidation process and ineffective reorganization process may be highly creditor protective as the ineffective reorganization process may never be used (La Porta et al., 1998).

When examining the theories regarding creditor protection rights and firm value one asserts. This theory suggests a direct negative relationship between creditor rights and firm value. It argues that stronger creditor rights induce companies to engage in risk-reducing investments that might be value decreasing because strong creditor rights in default situations can result in inefficient liquidation processes erasing the firm’s option of continuation. This could result in costs which negatively affect shareholder value. Moreover, creditor rights directing the dismissal of management lead to additional private costs for managers and in order to avoid these costs managers decrease the probability of financial distress by reducing cash flow risk and diversifying. This risk reduction may lead to the foregoing of lucrative investments and value loss. Therefore, strong creditor rights can constitute deadweight cost for companies and the economy at all (Acharya et al., 2011).

In contrast, growing literature that suggests creditors have more power than they were previously assumed to have, indicates a positive relationship of creditor protection rights and firm value. The creditor’s power is not just suspected to be influential in default situations, but in non-default situations as well. After a financial covenant violation creditors have the right to immediate repayment, but instead of opting for this immediate repayment they use the chance of a waiver violation to impose stronger restrictions on the debtor by renegotiating the credit agreement, resulting in amended credit agreements with less funding, having higher interest rate spreads and shorter maturities (Nini et al., 2012). Due to a lower possibility of managerial expropriation induced by improved monitoring of creditors, the agency costs are assumed to decrease, positively affecting firm value.

In principle, empirical evidence for a relationship between creditor protection rights and firm value is scarce and more limited when investigating this relationship in the case of M&As because most of the research is focused on shareholder or investor protection rights and their relationship with firm value. However, one of the central articles for this study is from Acharya et al. (2011), who confirm the theory of a negative relationship between creditor protection rights and firm value in their cross-country analysis. By examining cross-border M&As they

show that stronger creditor protection rights have a negative effect on corporate risk-taking as managers tend to engage in diversifying acquisitions which are firm value destroying as opportunistic behaviour of managers increase and bona fide risky investments are foregone. This finding holds across countries as well as across industries (Acharya et al., 2011).

Nonetheless, the study of Nini et al. (2012) was able to provide proof of a positive relationship between creditor protection and firm value as theorized above. They were examining SEC filings of US non-financial firms from 1996 to 2008 and found that in every year about 10 to 20 percent of companies report violations of financial covenants in credit agreements. Moreover, their findings show that covenant violations were followed by a decline in capital expenditures, acquisitions, a reduction of shareholder payouts and leverage and higher CEO turnover positively affecting firm value. However, this positive relationship could just be shown after violations of covenants which can be seen as firm-specific creditor rights, but this research will not be able to do that. Therefore, the negative relationship which might be softened by a possible positive relationship is expected. Consequently, the following hypothesis was developed:

H2: There is a negative relationship between creditor protection rights and firm value in the case of M&As.

In the literature, several theories which suggest that creditor protection not only impacts firm value, but could also influence the relationship between corporate governance and firm value can be found. First of all, La Porta et al. (1998) say that an increase of creditor protection leads to a decrease of other rights such as shareholder protection rights incorporated in the firm-level corporate governance score. In turn, this might be an indication for a negative moderating effect on the assumed positive relationship of corporate governance and firm value. Moreover, weaker corporate governance induced through weak shareholder rights increase the probability of the agency conflict type 3 which could lead to more expropriation of minority shareholders by majority shareholders as more expropriation means higher agency costs which results in lower firm value (Gompers et al., 2003).

Furthermore, Acharya et al. (2011) suggest that stronger creditor rights lead to a reduction of corporate risk-taking since managers engage less in riskier and firm value enhancing investments. The managers’ behaviour derives from the fact that they want to protect the company of going bankrupt in case it is not able to pay back its credit which might lead to liquidation or reorganization of the company and managers losing their employment.

Therefore, managers engage in diversifying and at the same time value destructing M&As as it decreases risk. This additional effect can be linked to the risk-taking behaviour and agency conflict type 2 since high creditor rights lead to lower expropriation of creditors by controlling shareholders. Therefore, forgoing bona fide risky investments can be seen as agency costs induced by creditor rights which are decreasing firm value. Moreover, creditor rights represent a counter force to corporate governance since creditor rights protect the interest of debt providers and corporate governance protects the interest of equity providers. This also complies with McColgan’s (2001) statement that effective corporate governance can reduce agency problems and its corresponding costs. Despite Acharya et al.’s (2011) study, no research including relevant information regarding creditor rights and firm value in case of M&As could be found.

Moreover, there is growing literature such as Brockman and Unlu (2009) and Nini et al. (2012) supporting the ability of strong creditor rights reducing agency costs of debt as weaker creditor protection represent additional costs for creditors if they do not agree on additional control rights. For instance, creditors in low creditor protection countries demand additional control rights since they are not confident when it comes to recovering claims during the bankruptcy procedure. In addition, if creditors do not have absolute priority over non-secured claims while the debtor is in bankruptcy the probability of full recovery declines constituting costs for creditors (Brockman & Unlu, 2009). Moreover, additional control of creditors could lead to better monitoring of managers. (Hart, 1995). This would then negatively affect the agency cost deriving from the agency conflict type 1. Consequently, strong creditor rights reduce agency costs which might lead to higher overall firm value.

However, since the positive relationship of creditor rights and firm value could just be found in Nini et al. (2012)’s study after a covenant’s violation this effect is not assumed to appear and if it should appear it is just expected to weaken the negative relationship of creditor rights and firm value.

Therefore, it can be expected that combining the effects of creditor protection rights affecting corporate governance, its relationship with firm value and the direct effect of creditor rights on firm value, it is assumed that the firm value in case of M&As is going to decrease. Hence, it can be hypothesized that:

H3: The relationship between corporate governance and firm value is negatively moderated by the creditor protection rights of the acquiring country in the case of M&As.

3 Data and Methodology

This section will provide a description of the approach used for data gathering and data complementing. Furthermore, methods and actions applied to investigate the research question will be presented. Primarily, the data part includes information regarding the sample, its distribution and descriptive statistics. Subsequently, the methodology part will comprise of the regression model and a brief description of all the corresponding variables.

3.1 Sample

Since this study examines the effects of corporate governance, firm value and creditor protection, data of M&A deals are important to obtain in order to test the hypotheses. In general, this study is built on a quantitative empirical approach which relies on secondary data gathered from various sources. Probably one of the most comprehensive and commonly used databases for M&A deals is the Zephyr database by Bureau van Dijk and served as a basis for the deal selection.

M&As provide the perfect conditions to test the hypotheses because they are crucial drivers of corporate performance and means with which firms react to changing conditions (Yen & Andre, 2007). Therefore, the deal type was limited to solely mergers and acquisitions meaning that e.g., joint ventures and institutional buy-outs are excluded. Moreover, the acquirer was limited to listed companies as this facilitates the data collection and helps to ensure that sufficient data for the acquirer is publicly available. Regarding the target company data availability requirements are not as high and therefore both, listed and unlisted targets are accepted.

Another filter applied to specify the sample is referring to the method of payment. Several studies (see, e.g., Faccio & Masulis, 2005; John, et al., 2010; Martynova & Renneboog, 2008; Masulis et al., 2007) examined the different influences of the type of method of payment on the deal and therefore it is logical to only include the deals made with method of payment of cash or shares.

Since literature suggests that the corporate governance of the acquirer will be imposed on the target when the acquirer reaches a controlling stake in the target (Martynova & Renneboog, 2008) solely M&As with an initial stake of up to 49% and a final stake from 51% onwards were included.

Finally, only deals with the current deal statues completed and confirmed and those with a minimum deal value of 10 million Euro are included.

The initial time frame for this study was 15 years stretching from January 1st_{, 2000 to}

December 31st_{, 2015 which led to a sample size of 11,646 deals. However, due to a lack of data}

availability of the corporate governance score, the timeframe was reduced to 14 years. Moreover, the data availability of corporate governance led to a drastic cut of the sample to about 469 deals when matching the corporate governance score of the announcement year with the deals via the International Securities Identification Number (ISIN).

Additionally, the sample got further reduced by removing deals from companies which pursued several deals within the timeframe in order to prevent a bias in the measurement of firm value. Besides, to provide more comprehensive information about the sample, the next section is going to analyse the sample distribution.

3.2 Sample distribution

This section provides insights into the sample distribution of the 331 deals within the 14-year timeframe, beginning in 2002 and ending in 2015. It focuses on the distribution of the deals over the years (Table 1), the distribution of the acquirer and target countries which can be found in Appendix 1 and 2, and the industry distribution of the acquirer and target (Table 2).

When analysing the yearly distribution of M&A deals in Table 1, the number of deals within the timeframe are well distributed. The average deals per year would be approximately 24 deals and the range of the yearly number of deals lies between the minimum of 16 in the year of 2009 and the maximum of 30 in 2007. The maximum and minimum number of deals show a certain proximity regarding the period. The peak of M&A deals in the year 2007 which was followed by a drastic decrease might be explained with the financial crisis which occurred during the years of 2008 and 2009. Therefore, effects of the financial crises might have led to weaker M&A activity. Moreover, it is necessary to mention that this abnormality could also be caused by data availability since this study solely includes acquirers whose firm-level corporate governance score is publicly available.

Table 1: Yearly distribution of M&A deals

Year Frequency Percent Cumulative

2002 24 7.25 7.25 2003 27 8.16 15.41 2004 27 8.16 23.56 2005 27 8.16 31.72 2006 25 7.55 39.27 2007 30 9.06 48.34 2008 18 5.44 53.78 2009 16 4.83 58.61 2010 28 8.46 67.07 2011 21 6.34 73.41 2012 19 5.74 79.15 2013 20 6.04 85.20 2014 26 7.85 93.05 2015 23 6.95 100 Total 331 100

This tables provides a distribution of all M&A deals included in the 14-year timeframe relevant for this study. The deals are divided according to their announcement year.

Table 2: Distribution of M&As across industries

SIC-Code Acquirer industry %

Target

industry %

B 10 - 14 Mining 19 5.74 20 6.04

D 20 - 39 Manufacturing 112 33.84 94 28.40

E 40 - 49 Transportation & Communications 36 10.88 35 10.57

F 50 - 51 Wholesale Trade 15 4.53 11 3.32

G 52 - 59 Retail Trade 11 3.32 8 2.42

H 60 - 67 Finance, Insurance & Real Estate 91 27.49 85 25.68

I 70 - 89 Services 47 14.20 78 23.56

331 100 331 100

This table provides the distribution regarding industries of all M&A deals included in the 14-year timeframe relevant for this study. The deals are divided according to the two digit SIC-code which were collected from the Zephyr database. Industry classification A (01 – 09 Agriculture, Forestry & Fishing) and C (15 – 17 Construction) were excluded as this sample did not include companies operating in these fields.

When analysing the distribution of M&As across countries (Table 2) classifying them according to the industry they operate in, the highest share in both, the acquirer industry and the target industry derives from the manufacturing industry with 33.84% and 28.40% respectively. The second largest industry represented in the sample is Finance, Insurance and Real Estate (H) with 27.49% of the acquirer and 25.68% of the target operating in this sector. The third largest industry represented is the Services industry with 14.20% of the acquirers and 23.56% of the targets coming from that field. The fourth largest industry is Transportation and

Communication with 10.88% of the acquirer and 10.57% of the target working in this industry. Regarding the relatively high share of companies operating in the field of Electric, Gas, & Sanitary Services (included in E) and Finance, Insurance and Real Estate (H), a variation of the sample will be created so acquires operating in these sectors will be excluded. Financial services and utilities companies usually have other specifications such as high leverage (Fama & French, 1992). Therefore, the test will be run with and without financial services and utilities companies with the two digit SIC-codes 49 and 60 to 67. The following section concludes the data part of this study by stating and analysing the descriptive statistics of the most important variables used within the model.

3.3 Descriptive Statistics

Table 3 illustrates the descriptive statistics of the most important variables incorporated in the main model 1.1. The dependent variable, cumulative abnormal return +/- 3 days from the announcement date (CAR3) which is used as a proxy for firm value shows a positive mean of 0.0022 which indicates that the average cumulative abnormal announcement returns for the sample of 331 observations is positive. This also holds for the CAR1. In contrast, the CAR5 with a timeframe of 11 days shows on average slightly negative abnormal announcement returns. Moreover, the standard deviations for all three CARs are relatively high which leads to not significant results for CAR1 and CAR5.

The main independent variable, corporate governance (CG) shows a relatively high average corporate governance score of 68.6086 on a scale of 0 to 100. This could be an indication for biased data as in order to develop that score a certain extend of publicly available information is required. However, the minimum score of 1.58 and a maximum score of 97.54 combined with a standard deviation of 23.5672 indicates certain variation within the score.

Examining the variable investor protection rights (IPR), which is used as a proxy for corporate governance in the alternative model shows that its correlation with corporate governance is surprisingly low with a value of 0.3439. The correlation between these two variables was expected to be higher since shareholder protection rights which is a major part of the variable investor protection rights are incorporated in the CG variable. Moreover, the descriptive statistics for IPR indicates a slightly lower average of 0.6155 on a scale of 0 to 1 than the one of the CG variable.

The next variable is the creditor protection rights index. This index ranges from 0 to 4 with single observations either taking values of 0, 1, 2, 3 or 4. Therefore, the mean of 1.58006 is relatively low indicating weak creditor rights in the acquirers’ home countries.

Referring to the control variable, firm size (AFS) the standard deviation is relatively low indicating low dispersion of the data values which seems logical as due to data availability of the corporate governance score the companies included are required to have a certain size.

The other control variables, such as leverage (LVG), firm age (AGE) and return on equity (ROE) all have relatively high standard deviations. The highest one in relation to the mean is from ROE. Moreover, the minimum ROE lies at -125.2825 and the maximum lies at 211.5050. When it comes to the leverage the mean lies at 210.1896 and the values range from -71.0600 to 4407.0600. The values of the ROE and LVG might be influenced by the relatively high share of financial services companies (Fama & French, 1992).

Table 3: Descriptive statistics - Main Model 1.1

Variable Obs. Mean Std. Dev. Min. Max.

CAR3 331 0.0022 0.0641 -0.2456 0.3435 CAR1 331 0.0018 0.0511 -0.1926 0.2948 CAR5 331 -0.0008 0.0704 -0.2616 0.3501 CG 331 68.6086 23.5672 1.5800 97.5400 IPR 331 0.6155 0.1755 0.1722 1.0000 CPR 331 1.5801 1.0796 0.0000 4.0000 CGxCPR 331 105.1497 84.6676 0.0000 380.2400 IPRxCPR 331 1.0295 0.9901 0.0000 3.8500 AFS 331 17.4341 1.7386 12.8296 21.6722 LVG 331 210.1896 392.2596 -71.0600 4407.0600 AGE 331 58.2387 49.3026 3.0000 290.0000 ROE 331 15.6706 23.8080 -125.2825 211.5050 DV 331 13.4295 1.8360 9.2830 17.83330

This table shows the descriptive statistics includes the most important variables for the model. CAR1 and CAR5 are included because they are going to be used for robustness tests in one of the following sections. The main independent variable is CG which is followed by CPR and the moderator CGxCPR. Moreover, the additional variable for the alternative model, IPR and the corresponding moderator IPRxCPR are included as well. The other variables are control variables specific for the field of M&As. The dummy variables included in the model were left out for the descriptive statistics as they do not play an important role for the hypotheses and do not provide the reader with meaningful information.

3.4 Model

This section will provide the model which was set up in order to test the hypotheses built in the literature review. The central variables of interest for the main model (1) of this study are firm value (FV) which is the dependent variable and will be explained by firm-level

corporate governance (CG), country-level creditor protection rights (CPR) and the moderating effect of creditor protection rights (CG*CPR) on the relationship of corporate governance and firm value. Moreover, the model includes the error term () and controls for the several variables which are stated in detail in Appendix 3.

Main Model:

FV=α+β1*CG+β2*CPR+β3*(CG*CPR)+controls + (1)

In order to see if this study will find the same positive relationship between investor protection rights and firm value as John et al. (2008) did in their research an alternative model will be set up.

The alternative model (2) is identical to the main model except that it utilizes the investor protection rights (IPR) on a country-level instead of the firm-level corporate governance score as a proxy for corporate governance. Therefore, also the moderator (IPR*CPR) changes leading to the following equation:

FV=α+β1*IPR+β2*CPR+β3*(IPR*CPR)+controls+ (2)

3.5 Variables

This section will provide a brief description of the variables included in this study, and how they were measured, as well as the sources from which they were gathered.

3.5.1 Dependent Variable – Firm Value

Previous literature about firm value shows that there are several methods available to calculate and measure it. Some of the most important ones are, Tobin’s Q, buy-and-hold returns and the cumulative abnormal announcement return. For example, Tobin’s Q was used by Bris & Cabolis (2008), Gompers et al. (2003), Bhagat and Bolton (2008), and Shleifer and Vishny (1997) However, according to Dybvig and Warachka (2010) an endogeneity problem occurs when Tobin’s Q is used as a measurement for economic implications of corporate governance. Therefore, Tobin’s Q will not be used for this research. Moreover, the buy-and-hold returns are used for instance, by Drobetz et al. (2004) and by Basuil and Datta (2015), but since it examines rather long-term effects it is also not the most suitable for this study.

Therefore, the dependent variable used for this study is the cumulative abnormal announcement return (CAR) which is used as a proxy for firm value. The CAR is a commonly used measurement for event studies in M&As. For instance, it was used by Masulis, Wang and Xie (2007), Nini et al. (2012) and Acharya et al. (2011). Moreover, as this measurement examines the effect of an announcement it is rather short- than long-term. For instance, Nini et al. (2012) use it in their study about creditor control rights, corporate governance and firm value to measure the latter one. In general, the calculation of CAR is based on MacKinlay (1997) and therefore it will not be stated in detail.

As suggested in the article of MacKinlay (1997), the CAR requires an estimation window which was set to 254 to 4 trading days before the event window which is approximately equal to 51 regular weeks. Since additional deals of the same acquirer within this estimation window may bias the outcome the sample was corrected for that by removing deals interfering with the estimation window of deals ultimately staying in the sample. The event window was set to 3 days prior to the announcement date and 3 days after in order to capture 5 trading days and 7 regular days. For the CAR it is crucial that the estimation window and the announcement window do not overlap as this may cause biased results. Moreover, the market model incorporates the S&P 500 index as it is the most suitable index referring to the acquiring companies’ listings. The abnormal returns were computed from data regarding stock price returns taken from Thomson Reuters Datastream to calculate the market model for the estimation window. Moreover, the fitted value was calculated and in the next step this value was subtracted from the market model to derive at the abnormal returns. These abnormal returns were then aggregated to arrive at the CAR.

3.5.2 Independent Variable – Corporate Governance

The independent variable of this research is corporate governance which is going to be measured by the firm-level corporate governance score gathered from the ASSET4 database. In contrast, to several other studies who measured corporate governance on a country-level (see, e.g., John, et al., 2008; Martynova & Renneboog, 2008) a firm-level corporate governance score adds more variation to the dataset and provides more precise information which should better explain the dependent variable. The corporate governance score is relatively new and is only available from the year 2002 onwards for a limited number of companies. This led to a step sample reduction indicated before.

The detailed definition of the corporate governance score incorporated in the ASSET4 database is provided in Appendix 4. However, in general it focuses on the board of directors

and the executive management as mechanisms to serve in the equity holder’s best, long-term interest, and therefore does not include creditors in its scope as it was done for example, by Shleifer and Vishny (1997)’s definition.

Five main aspects covered by this corporate governance score are board structure, compensation policy, board functions, shareholder rights and vision and strategy. In addition, the score has a positive scaling from 0 to 100, meaning that a company with a 0 score has virtually no corporate governance and one with a 100 score has the perfect corporate governance.

3.5.3 Moderator – Creditor Protection

When it comes to the moderator of this relationship, creditor protection, the measurement of it will be done by using the creditor rights index of Djankov, McLiesh and Shleifer (2007). In addition, it is also used by Seifert and Gonenc (2016) and Acharya et al. (2011) who use it as a robustness check. The creditor rights index is generally based on La Porta et al. (1997). However, the method of Djankov et al. (2007) uses new data available for legal creditor rights and extended the number of countries used in their sample. Therefore, Djankov et al. (2007)’s index is the preferred one. The index checks for four criteria of creditor rights and then provides a value between 0 (very low creditor rights) to 4 (very strong creditor rights). Since Djankov et al. (2007) creditor protection rights index ends with 2003 the values of their 2002 creditor protection rights index were used for the whole timeframe of 2002 to 2015. The assumption of constant creditor protection rights from 2002 onwards can be made since creditor rights generally do not change significantly over time. For the 24 different acquirer countries the creditor rights just changed 5 times in the timespan of 1978 to 2003. Furthermore, this approach of extending the creditor rights index was also used by Seifert and Gonenc (2016).

3.5.4 Control Variables

Besides the aforementioned variables which affect firm value, there are several other factors which are likely to affect firm value as well. Therefore, a set of control variables commonly used in M&A literature will be added and discussed.

The first control variable which is part of the acquirer characteristics is the acquirer’s firm size. The reasoning for this variable to affect firm value was mentioned by Roll (1986) and relates to the hubris hypothesis. This hypothesis says the more self-confidence a management team or a company has the more likely it is to oversee crucial aspects and induce errors. Therefore, one can conclude that the larger the acquirer’s firm size the higher the

probability of overpaying the target. In turn, this could lead to lower returns and negative interrelation between firm size and the acquirer’s returns (Martynova & Renneboog, 2008). The firm size was calculated as it was done in the study of Garfinkel and Hankis (2011) by taking the natural logarithm of the acquirer’s total assets.

Another variable which is controlled for is the acquirer’s leverage. Jensen’s (1986) free cash flow theory suggests that high cash flows and low levels of leverage lead to a higher probability of managers engaging in value destructing acquisitions which in turn lead to lower or negative returns (Martynova & Renneboog, 2008). Moreover, a company’s debt level is crucial for guiding managers in the right direction as an optimal leverage helps them to weigh the disadvantages of forgoing on profitable deals caused by low future cash flows against the advantages of decreasing the probability of engaging in value destructing diversifying acquisitions (Stulz, 1990). This gives an indication that higher levels of leverage might have a positive impact on the firm value. The leverage is the percentage of the total debt of the common equity. The data for these two control variables were collected from Thomson Reuters Datastream.

In addition, this study controls for the age of the acquirer which is calculated by subtracting the year of incorporation from the current year. The year of incorporation was collected from the Zephyr database. This variable is a common control variable in the M&A literature and was for instance, used by Masulis et al. (2007) in their study about corporate governance and acquirer returns. The reasoning for including this variable is experience of the acquirer (Reuer & Ragozzino, 2008).

Moreover, the profitability prior to the announcement will be controlled for as it may affect post-deal returns. If a company was performing well before the deal it might be the reason for positive returns after the deal as well. This may be misleading since positive returns post-deal could also be due to the deal itself (Basuil & Datta, 2015). The profitability measurement of the acquirer is the average return on equity (ROE) of the three prior years of the announcement and was collected from Thomson Reuters Datastream.

Besides the acquirer characteristics, it is also important to control for deal characteristics. One of the most common deal characteristic control variables used for M&As is the method of payment. Research such as Faccio and Masulis (2005), John et al. (2010), Martynova and Renneboog (2008), and Masulis et al. (2007) include the effect of method of payment on returns. However, their findings are mixed. John et al. (2010) argue when the method of payment is stock it may increase the trust between the shareholders of the acquirer and target since the owners of the target receive an ownership in the new firm and risks are shared with

the shareholders of the acquiring firm. Moreover, a payment made in stocks might lead to positive returns as it signals that the stocks are not overvalued. In contrast, Masulis et al. (2007) find negative returns when the payment was made in stocks.

Another crucial deal characteristics control is the deal value. The deal value can be considered as the firm size of the target and is calculated by taking the natural logarithm of the deal value as it was done by John et al. (2010). According to Masulis et al. (2007) it can be assumed that a larger target leads to higher returns since the more is paid for a target the higher the expected gain. Aybar and Ficici (2009) also found a positive relationship between target size and bidder value. However, there might be other factors which impact the deal and result in negative returns.

Furthermore, this study is going to control for diversification. The Zephyr database provides a SIC (Standards Industrial Classification) code for both, the acquirer and the target involved in a deal. These codes can be used to identify if a deal had a diversifying purpose or not. If the first two digits, of the four digit SIC code, are the same then a deal can be classified as diversifying or horizontal M&A. The literature, argues that these horizontal or non-diversifying M&As have a positive effect on the shareholder value (Martynova and Renneboog, 2008). Similar to this study, a dummy variable will be used to indicate if a deal is diversifying or not, where non-diversifying deals receive a value of “1” and diversifying deals receive a value of “0”.

The last deal characteristic for which this study controls is if the deal is cross-border or not. This will be done by using a dummy variable. According to literature (Aybar & Ficici, 2009; Datta & Puia, 1995) cross-border M&As, on average, do not create value. Aybar and Ficici (2009) found support that if the bidder is of high-tech nature and if the target operates in a similar industry as the bidder, the returns are negatively affected.

In addition to acquirer and deal characteristics, it is also important to control for country characteristics such as the legal origin of the acquirer’s country or accounting standards followed. The legal origin influences various institutional variables within a country such as shareholder- and creditor rights (La Porta et al., 1998) and also relates to the probability of bankruptcies (Claessens & Klapper, 2005). The sample includes English, French, German and Scandinavian origins which are stated according to their frequency.

Lastly, this study controls for the accounting standards followed. According to La Porta et al. (1998) some accounting standards induce higher cost when making research about acquiring another company, especially if the target is not publicly listed. This leads to lower competition when trying to acquire a company which in turn leads to lower premiums. In