With the coffers of many companies bulging with cash, an upsurge in corporate mergers and acquisitions could easily be in the offing. And, just in time, a new study provides a caution for shareholders who find themselves scratching their heads when, as frequently happens, an acquirer's stock takes a hit upon announcement of a corporate merger.
At the same time, the new research provides a vivid reminder of just how hazardous corporate acquisitions are for top management.
All too often, a quick rebuff from the market is only the beginning of the acquiring company's woes, according to research in the current issue of the American Accounting Association's journal Accounting Review. The initial stock price drop frequently proves to be anything but a temporary setback and instead becomes the precursor to manipulation of earnings by company managers culminating in a financial restatement and dismissal of the CEO.
In the study of some 2,300 firms that made corporate acquisitions, three accounting professors from the University of Arizona's Eller School of Management find that firms in the lowest quartile in terms of stock market response to the news were about 50 percent more likely than other acquirers to misstate and then have to restate their subsequent finances. This means that the firms failed to apply accounting rules properly or even engaged in outright fraud.
Further, 34 percent of the CEOs in that lowest quartile of the acquirers were dismissed within five years after the merger, as compared to 20 percent of the chiefs in the top quartile.
In sum, the paper finds "a negative association between M&A announcement returns and the probability of issuing materially misstated financial statements following the M&A transaction."
And, while most executives responsible for badly received acquisitions don't misstate earnings in the post M&A period, even those who give an accurate accounting tend to issue overoptimistic earnings guidance. Both of these dodges, the study finds, mitigate the increased likelihood of CEO dismissal following a negatively received acquisition, but the effect proves only temporary once misstatements or overoptimistic forecasts are exposed.
"The study ought to serve as a warning to shareholders and corporate directors about the possibly dire implications of an initially negative market response to an acquisition," comments professor Daniel Bens, who carried out the research with his Eller colleagues Theodore Goodman and Monica Neamtiu. "At the very least, a substantial dip in stock price should evoke caution and vigilance and ought not to be simply shrugged off as simply a transient phenomenon."
The paper's findings are based on an analysis of 2,293 corporate acquisitions by US public companies during the twelve-year period of 1996 through 2007, in all instances of which deal values amounted to at least 5 percent of acquirers' market capitalizations. Investor response was gauged by the market-adjusted change in acquirers' stock price in the three-day period extending from the day before M&A announcements through the day after. For the sample as a whole, this consisted of a rise of 0.9 percent, while for the lowest quartile of responses it meant a mean drop of 2.3 percent.
To capture financial misreporting related to negative market reaction and not to something else, the study restricts itself to misstatements started within a year of the mergers' conclusions, although the misreporting typically lasts for several years before being discovered and then restated. The professors allow for a one-quarter buffer period between the M&A date and the beginning of the restatement measurement window to ensure that the acquirers' management had time to comprehensively evaluate the implications of the recent acquisition.
Overall, about 13 percent of the 2,300 companies in the sample issued financial restatements in the post-M&A period. Among companies in the lowest quartile in terms of market reaction, about 18 percent did so, compared to somewhat under 12 percent for the remaining three-fourths of the sample. While the study's findings are based on the first acquisition undertaken in the twelve-year period covered by the study, the results are robust enough to remain unchanged even when the professors expand the scope of their analysis to include multiple transactions per acquirer.
Noting that "acquisitions are among the most significant corporate resource-allocation decisions that managers make over their careers," the professors explain that, "unlike annual stock returns, which can vary for many reasons that are not controllable by a firm's management, the announcement of an acquisition provides insight into shareholders' reaction to a specific managerial decision. . . . Managers who face heightened career concerns from a negatively received M&A transaction have strong incentives to report value creation in the acquisition implementation stage. . . . Overall, [our] findings indicate that managers are more likely to issue misstated financial statements following poorly received M&A events in an attempt to improve post-M&A performance."
Companies in the sample that experienced slowdowns or downturns in the years following poorly received acquisitions include the global electronics manufacturer Solectron Corporation, whose stock declined by more than 12 percent over three days when it announced a major acquisition late in 2000 and which restated earnings in 2005 for three previous years; pharmaceutical company Chiron Corporation, whose stock declined about 2 percent at the time of an acquisition announcement in 2003 and which restated earnings two years later; and real estate giant Macerich, whose stock declined more than 4 percent at the time of an announcement in 2004 and which restated its finances in 2008.
Source: American Accounting Association