It Pays to Follow the Leader

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday February 24, 2012 at 9:29 am
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Editor’s Note: The following post comes to us from Amy Dittmar and Di Li of the Department of Finance at the University of Michigan, and Amrita Nain of the Department of Finance at the University of Iowa.

Financial bidders like private equity firms often compete with corporate bidders for the same target. Over the last 27 years, financial sponsors made 23 percent of all competing bids. In our paper, It Pays to Follow the Leader: Acquiring Targets Picked by Private Equity, forthcoming in the Journal of Financial and Quantitative Analysis, we examine how the presence of financial sponsor competition affects corporate buyers. Financial bidders are considered experts in the business of identifying undervalued targets. Gains from acquiring an undervalued firm pursued by private equity may accrue to any winning bidder that pays a similar premium for the target. Moreover, existing research shows that financial bidders have lower average valuations than strategic bidders. Thus, a corporate acquirer competing with a financial bidder (which is typically private) may win the auction at a lower premium than when it competes with another public corporate firm.

We find that corporate acquirers who purchase targets that are sought after by financial buyers outperform corporate acquirers who buy targets bid on by corporate firms only or those without competition. These results are robust to alternative measures of acquirer performance and different performance windows. A battery of tests shows that deal characteristics, acquirer abilities, and observable target characteristics cannot explain this difference in returns.

Why does competing with a financial sponsor lead to better performance? We propose that financial buyers identify targets based on unobservable characteristics with a high potential for value-improvement. If financial buyers are good at finding undervalued targets, other bidders can pursue the same targets and benefit from the target’s undervaluation. We show that the superior acquirer returns discussed above are concentrated in the sub-sample of acquirers who followed a bid by a financial sponsor. Firms earn a higher abnormal return if they follow a financial bidder than if they follow a corporate bidder. These results indicate that, at least in part, financial bidders identify targets with a high value of control, from which the ultimate winner benefits, thus indicating that benefits are transferable.

Our finding that corporate acquirers who purchase targets desired by financial bidders earn significantly higher positive abnormal returns goes somewhat against the popular view that corporate acquirers are not as good at delivering value from acquisitions as private equity buyers. The business press often lauds the ability of the private equity industry to select undervalued targets and take focused, performance-improving actions post-acquisition. Buy-out firms are thought to be better at incentivizing and guiding target management toward cost cuts and revenue growth after the acquisition is completed. We show that corporate acquirers can also deliver high returns when they purchase targets sought by private equity firms. Thus, our results suggest that while financial buyers are more skilled at selecting targets that have a high potential for value improvement, corporate buyers are competent in exploiting this potential.

The full paper is available for download here.

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