ELSEVIER Japan and the World Economy 7 (1995) 145-154

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E CO N O M Y

An explanation of bidder returns in corporate acquisitions: the case of Japanese acquisitions

of U.S. firms

E n y a n g G u o a A r t h u r J. K e o w n b , . , N i l a n j a n S e n c

a MillersviUe University, Millersville, PA, USA b Department of Finance, Virginia Tech, Blacksburg, VA 24061, USA

C Arizona State West University, Phoenix, AZ, USA

Received May 1993; accepted May 1994

A b s t r a c t

Over the past three decades researchers have found a dramatic drop in the returns generated by acquiring firms in domestic acquisitions, dropping to a level insignifi- cantly different from zero during the 1980s. In this paper we find this not to be the case for Japanese firms that acquire domestic U,S. firms. Moreover, contrary to what has been found for domestic acquisitions, a positive relationship was found between free cash flow and the returns accrued by the Japanese acquiring firm. This result may be a result of the institutional participation in the management of Japanese firms playing a role in eliminating agency problems for them.

Keywords: Mergers; Acquisitions; Japan

JEL classification: G34

T h e behav io r of c o m m o n stock pr ices of t a rge t and acquir ing f irms su r round ing a t e n d e r offer is well d o c u m e n t e d . Whi l e it is c lear t he re a re posi t ive r e tu rns to the ta rge t sha reho lde r s , it is much less c lear w h e t h e r the r e tu rns to the sha reho lde r s of the b i d d e r f irms are posi t ive. F o r example , J ensen and R u b a c k (1983) e s t ima te tha t excess r e tu rns to b i d d e r f irms in t e n d e r offers average app rox ima te ly 4 pe rcen t . Ja r re l l e t al. (1988) examine

* Corresponding author. Tel. (703) 231-8647, fax (703) 231-4706, e-mail: Emily@VT.edu

0922-1425//95/$09.50 © 1995 Elsevier Science B.V. All rights reserved SSDI 0922-1425(95)00021-K

146 A.J. Keown et al. //Japan and the World Economy 7 (1995) 145-154

acquisitions over the 1960s, 1970s, and 1980s and find that while the excess return to bidder firms has on average been positive over the entire period, excess returns average negative 1 percent during the 1980s, although not statistically significant. Similar results indicating a decline in the excess returns earned by bidders were found by Bradley et al. (1988). While they found excess returns averaging over 4 percent during the 1960s, bidder excess returns were found to turn negative during the 1980s and average approxi- mately negative 3 percent.

A number of possible hypotheses have been forwarded to explain the returns to bidder firms, including elimination of inefficient management, free cash flow returns, synergistic effects of the acquisition, signalling, undervalu- ation of the target firm, the method of payment, managerial reaction, elimination of agency problems, the hubris or the winner's curse, and the creation of market power. While these explanations provide insights as to the creation of wealth in the domestic setting, there may be additional factors at work in the case of cross country acquisitions. Recent evidence indicates that the residence or the acquiring firm may affect the target firm's abnormal returns. For example, Cebenoyan et al. (1989), Harris and Ravenscraft (1991), and Kang (1991) found evidence that abnormal returns were higher to firms with cross border bidders than for firms with domestic bidders. One possible explanation may be that differing managerial styles allow for the reduction of greater inefficiencies and therefore the creation of greater wealth. To what extent bidder returns are affected is not known.

If, however, more wealth is created in cross country acquisitions than in domestic acquisitions, then foreign bidders could pay prices significantly above what a domestic bidder might pay and still generate positive bidder returns. The purpose of the present study is to examine the behavior of foreign bidder stock prices, specifically Japanese bidders, to determine if foreign bidders received positive abnormal returns during the period of the 1980s, a period during which U.S. bidders experienced negative excess returns, and to offer an explanation as to what might have created those gains.

The remainder of the paper is organized into four sections. Section 1 briefly discusses related literature dealing with wealth creation from acquisi- tions. Section 2 provides a description of the data and methodology, while Section 3 examines the results. Finally, Section 4 presents concluding re- marks.

1. The generation of wealth from acquisitions

While there is no question that there is a wealth effect for target shareholders from takeovers, the presence of a wealth effect to acquiring

A.J. Keown et al. /Japan and the World Economy 7 (1995) 145-154 147

shareholders is in doubt. For example, while Jarrell et al. (1988) found positive excess returns above 4 percent for the 1960s, the excess returns were found to drop to about 2 percent, and for the 1980s dropped to about 1 percent and were not found to be statistically significant. Bradley et al. (1988) found a similar decline in excess returns to acquiring shareholders, dropping from about 4 percent in the 1960s to 1.3 percent in the 1970s, down to negative 1 percent and significant for the 1980s. Jarrell and Poulsen (1989) also found returns to acquiring firm shareholders to turn negative, although not significantly so, during the 1980s.

Recently, Cebenoyan et al. (1989), Harris and Ravenscraft (1991), Weston et al. (1990), Kang (1991), and Bello and Keown (1992) found evidence that foreign acquirers pay higher premiums for target firms than do U.S. acquir- e r s .

For example, Harris and Ravenscraft find that foreign acquirers pay premiums in excess of 10 percent more than do U.S. firms in acquiring other U.S. firms. Harris and Ravenscraft find that these premiums are related to cultural differences between the acquiring firm's country and the target firm's country, the intensity or importance of research and development in the target firm's industry, and the weakness of the U.S. dollar.

The question that we address in this paper is which returns are realized by acquiring firms, specifically Japanese firms, from cross border acquisitions in the United States, and which factors explain the acquiring firm's returns. For domestic acquisitions Jarrell and Poulsen (1989) found that the relative size of the acquisition and the existence of competing bids for the target both significantly affected the wealth effect of the acquiring firm. Asquith et al. (1983) had earlier found that abnormal returns earned by acquirers increase as the target size increases relative to the acquirer size. In effect, the smaller the target the less the value of the new information released in the an- nouncement. Lang et al. (1991), in examining successful tender offers, found an inverse relationship between free cash flow and bidder returns for low-q bidders thus supporting the free cash flow hypothesis. Comment and Jarrell (1987) and Bradley et al. (1988) both demonstrate that the existence of multiple bidders has a significant impact on the returns to acquiring firms, with acquiring-firm abnormal returns being significantly positive in single-bi- dder contests and insignificantly different from zero in multiple-bidder con- tests. Jarrell and Bradley (1980) and Jarrell and Poulsen (1989) also argue that the degree of competition among bidders is also a function of govern- ment regulation, which tends to change over time, with the Williams act in 1968 and the amendments to it passed in 1970 having a positive affect on the returns to target firms and a negative affect on the returns to acquiring firms. Morck et al. (1989) have suggested that the distinction between hostile and friendly mergers may be important in explaining returns. Interestingly, all of the takeovers of U.S. firms by Japanese firms identified in the sample were

148 A.J. Keown et al. /Japan and the World Economy 7 (1995) 145-154

friendly takeovers. Moreover, it has been suggested by Harris and Raven- scraft (1991) that Japanese firms do not become involved in hostile takeovers because of cultural reasons.

2. Data and methodology

The initial sample is obtained from Mergers and Acquisitions over the period January 1981 through December 1989. The specific event dates are taken from a search of the Dow Jones News Retrieval Service. The availabil- ity of return data for the Japanese bidding firms restricted the sample to 82 acquisitions. The Japanese return data used was taken from the Pacific Basin Capital Market Database while the data for U.S. target firms came from the Industrial Compustat and CRSP daily return file. The capital market re- sponse of the Japanese firms to these acquisition announcements is analyzed using standard event study methodology. The excess return around the event dates is estimated using the Pacific Basin Capital Markets Database Japanese market index, DVMRWT, which is made up of the daily value weighted market returns on all common stock listed on the Nikkei exchange with nonmissing returns and nonmissing market value. The parameters of the market model are estimated over a 250 day control period from day relative -265 to day -16 , with the event occurring on day 0. The t statistic for the significance of the average excess returns is calculated by dividing the average excess returns (AERs) by the standard deviation of the AERs, estimated from the time series data over the control period. The significance of the AERs is also estimated following the procedure described in Patell (1976) which standardizes the excess returns by the unbiased estimates of their standard deviation.

In order to shed light on the motivations of Japanese firms in cross border U.S. acquisitions we examine the role of several variables in explaining premiums earned by the Japanese acquiring firms including: 1) Exchange rate relative to its historical average. We expect a negative

relationship between the relative exchange rate defined as the yen per dollar and the excess returns earned by the bidding firm. As dollars, and therefore target firms, become less expensive in a relative sense we expect the bidding firm's abnormal returns to increase. This would be consistent with the results of Harris and Ravenscraft (1991).

2) Level of free cash flow of the acquiring firm. We expect a negative relationship between the free cash flow of the acquiring firm and the excess returns it earns. This would be consistent with the findings of Lang et al. (1991), who interpret this finding as evidence of agency problems, although due to the lack of data availability our measure of free cash flow is different from that used by Lang et al.

A.J. Keown et al. /Japan and the World Economy 7 (1995) 145-154 149

3) Asset growth level. We expect a positive relationship between asset growth and the excess returns earned by the bidding firm. High asset growth can be interpreted as control variable justifying the use of a liquidity measure (net income plus depreciation) as a measure of free cash flow. Moreover, if international expansion is the means used to enter into new markets and thereby maintaining past growth, then a firm with a higher growth rate should benefit more, producing a positive coefficient.

4) Sales growth level. We expect a positive relationship between sales growth and excess returns. Sales growth should provide a better proxy for growth opportunities than asset growth. Also, the higher the sales growth level the greater the benefits the firm should receive as it moves into new markets to maintain current growth levels.

5) The premium paid for the acquired firm. Consistent with Comment and Jarrell (1987), Bradley et al. (1988), and Jarrell and Poulsen (1989) we would expect the returns to the acquiring firm to decline as a result of competition and resultant higher premiums paid for the target firm.

6) The relative size of the acquired firm. We expect a positive relationship between the relative size of the acquired firm and the excess returns earned by the target firm. Consistent with Asquith et al. (1983) we expect a positive relationship between size and excess returns to the acquiring firm.

These variables are first examined using a simple linear regression with each variable examined separately. Those variables displaying some explana- tory power were then examined together using multiple regression.

These results indicated that the relative exchange rate, level of free cash flow of the acquiring firm, asset growth level, and sales growth level might all play some role in explaining the level of return experienced by the acquiring firm. In contrast to previous findings, the premium and size variable did not prove to be significant. Interestingly, free cash flow or liquidity took on a positive sign, indicating an absence of the agency problems found for U.S. acquisitions of domestic firms. These results are presented in the following section.

3. Results

The average excess returns for the Japanese acquiring firms are presented in Table 1. The event date corresponds to day relative 0. The average daily excess return has a value of positive 0.53434 percent on the announcement day and is significantly different from zero using both the traditional t statistic and Patell's standardized Z statistic. It is also positive on day - 1 , although not significant. Thus, acquisition announcements of U.S. firms by Japanese firms bring about a statistically significant positive reaction to the

150 A.J. Keown et al. /Japan and the World Economy 7 (1995) 145-154

Table 1 Excess returns for Japanese acquiring firms

OBS R E L D A Y Abnormal t statistic Standardized Patel return excess return Z statistic

3 - 5 -0.0018085 -0 .87160 -0 .08970 -0 .80227 4 - 4 0.0004226 0.20367 0.06541 0.58501

5 - 3 -0.0019776 -0 .95306 -0 .10380 -0 .92838 6 - 2 -0.0018048 -0 .86979 -0 .09119 -0 .82069

7 - 1 0.0018493 0.89122 0.16255 1.46296 8 0 0.0053434 2.57518 0.29204 2.61210

9 1 -0.0014009 -0 .67512 -0 .06852 -0.60519 10 2 -0.0003091 -0.14895 -0.02441 -0.21695 i1 3 -0.0014777 -0.71215 -0.04741 -0.42931 12 4 - 0.0006252 - 0.30131 -0 .03120 - 0.28077 13 5 0.0025954 1.25079 0.19519 1.74582

R E L D A Y denotes the relative day with day 0 being the announcement day. The standardized excess return is calculated using the Patel standardization.

Japanese firm, although not a large one. This is somewhat different from what has been found in some studies of domestic U.S. acquisitions of U.S. domestic targets. For example, Bradley et al. (1988), and Jarrell and Poulsen (1989) found returns to acquiring firms on domestic acquisitions were nega- tive during the 1980s. For the target firm the average excess return experi- enced on the announcement day was approximately 9 percent and in line with what was found in other studies for U.S. firms acquired by foreign and specifically Japanese firms, these results are presented in Table 2.

Ordinary least squares regression analysis is used to determine the ex- planatory power of the independent variables in explaining the abnormal

Table 2

Excess return for U.S. target firms

OBS R E L D A Y Abnormal t statistic Standardized Patel

return excess return Z statistic

1 - 5 0.014006 3.4658 0.56162 3.9313 2 - 4 0.005095 1.2608 0.24001 1.6800

3 - 3 0.001640 0.4059 0.04193 0.2935 4 - 2 0.004435 1.0974 0.10446 0.7237 5 - 1 - 0.000501 - 0.1240 - 0.02529 - 0.1752 6 0 0.089884 22.2422 4.04334 28.3034 7 1 0.009112 2.2549 0.54098 3.7868

8 2 0.000712 0.1762 -0 .02780 -0 .1946 9 3 -0.003146 -0 .7785 -0 .17770 - 1.2311

10 4 0.004615 1.1419 0.25668 1.7784 11 5 - 0.003020 - 0.7473 - 0.14456 - 1.0015

R E L D A Y denotes the relative day with day 0 being the announcement day. The standardized excess return is calculated using the Patel standardization.

A.J. Keown et al. /Japan and the World Economy 7 (1995) 145-154 151

returns of the Japanese acquiring firms. The sample includes 46 acquisitions of U.S. firms by Japanese firms. Six variables, the relative exchange rate, the acquiring firm's free cash flow, a dummy variable for large asset growth, a dummy variable for large sales growth, the dollar premium paid for the acquisition, and the relative size of the acquisition, are examined. The exchange rate variable was defined as the exchange rate at the time of the announcement less the average exchange rate over the period 1981 through 1989 divided by the exchange rate on the announcement day. The free cash flow variable, which can also be interpreted as a liquidity measure, was defined as the Japanese acquirer's net income plus depreciation divided by equity. The dummy variable for large asset (sales) growth took on a value of one if the acquiring firm's asset (sales) growth was in the top half of the distribution of asset (sales) growth for the entire sample. The premium paid for the acquired firms was measured as the percent premium of the an- nouncement day price over the targets price two months days prior. Only the coefficients for free cash flow, the dummy variable for large asset growth, and the dummy variable for sales growth were found to be significant, while the exchange rate variable had a p-value of 0.1753. 1 These four variables were then examined using multiple regression with asset growth and sales growth used in separate equations. Interestingly, the coefficient for the free cash flow variable took on a positive value. This is in contrast with that found by Lang et al. (1991), who found a negative coefficient for free cash flow for acquiring firms. They interpreted this as a sign of agency problems. This was not found to be the case for the Japanese acquiring firms, perhaps because of the institutional participation in the management of Japanese firms playing a role in eliminating agency problems for them. The relative size of the acquired firm is the market value of the target's equity divided by the market value of the acquiring firm's equity two months prior to the announcement.

The results of the multiple regressions presented in Tables 3 and 4 support the findings of the simple regression. The White (1980) test was also performed to examine heteroscedasticity in error terms. The statistic is distributed asymptotically as chi-square, with degrees of freedom equal to number of regressors (not counting the constant) in the regression used to obtain the statistic. The test results suggest no evidence of heteroscedasticity. Both the free cash flow variable and the large asset and, alternatively, sales growth dummy variables are found to be significant when the dependent variable, the acquiring firm's excess returns, is measured over days 0 and - 1. Moreover, the coefficient for the free cash flow variable again takes on a positive value. Again, providing support to the absence of agency problems in Japan. Keeping in mind the interwoven directorship relationship that

1 The results from the simple regressions are available on request from the authors.

152 A.J. Keown et al. /Japan and the World Economy 7 (1995) 145-154

Table 3 Multiple regression between excess return and the variables exchange rate, free cash flow, a proxy for large asset growth, and a proxy for large sales growth

Independent variables Coefficient T Prob > [ T I

Model 1: dependent variable: CER1, 2 Intercep - 0.002616 - 0.369 0.7140 E X R A T E - 0.038158 - 1.196 0.2383 CFE 82.75123 2.208 0.0328 A S G R O W 0.019449 1.809 0.0776

Model 2: dependent variable: CER1, 2 Intercep - 0.004092 - 0.659 0.5137 E X R A T E - 0.061363 - 1.954 0.0573 CFE 67.99479 1.889 0.0644 S A G R O W 0.03765 3.031 0.0042

CER1, 2 = cumulative excess return for Japanese firms at t = - 1 and t = 0, E X R A T E = (exchange rate( t) - mean of exchange rate during the sample per iod) /exchange rate(t), CFE = (net income + depreciat ion)/equi ty, A S G R O W = dummy of asset growth, dummy = 1 if the asset growth is larger than the average of the sample, S A G R O W = dummy of sales growth, dummy = 1 if the sales growth is larger than the average of the sample. Sales growth is defined as: [SALE(t ) /SALE(t -3)] 1 / 3 - 1, asset growth is defined as: [ASSET(t) /ASSET(t-3)] I / 3 - 1 . Multiple linear regression models: model 1: CER1, 2 = a + bl E X R A T E + b2 CFE + b3 AS- G R O W ; model 2: CER1, ~ = 1 + bl E X R A T E + b2 CFE + b3 SAGROW.

Table 4 Multiple regression between excess return and the variables exchange rate, free cash flow, asset growth, and a proxy of large asset growth

Independent variable Coefficient t statistic p value

E X R A T E - 0.050 - 1.633 0.11 CFE 0.0703 3.288 0.002 A S G R O W 0.016234 1.761 0.08

Intercept = - 0.005938, T = - 0.909, F = 0.37

E X R A T E = (exchange rate - mean of exchange ra te ) /exchange rate, CFE = (net income + de- preciat ion)/equity, A S G R O W = dummy variable = 1 if (assetyear t - assett_3 )1/3 is in top half of distribution. Dependent variable: cumulative excess return over t = 0, - 1.

J a p a n e s e f i n a n c i a l i n s t i t u t i o n s a n d t h e J a p a n e s e g o v e r n m e n t h a s w i t h

J a p a n e s e i n d u s t r y s u c h r e s u l t s a r e n o t t o t a l l y u n e x p e c t e d .

4. Summary

R e s e a r c h e r s h a v e f o u n d t h a t t h e r e t u r n s g e n e r a t e d b y a c q u i r i n g f i r m s i n

d o m e s t i c a c q u i s i t i o n s d r o p p e d d r a m a t i c a l l y s i n c e t h e 1 9 6 0 s , t o a l e v e l i n -

A.J. Keown et al. /Japan and the World Economy 7 (1995) 145-154 153

significantly different f rom zero. We found this not to be the case for Japanese firms that acquire domest ic U.S. firms. For a sample of 82 cross border acquisi t ions over the per iod 1981 through 1989 we found the average excess re tu rn ea rned by Japanese acquir ing firms to be 0.73 percent over the two-day a n n o u n c e m e n t period. Three variables, the relative exchange rate, free cash flow, and growth measured as e i ther assets or sales growth, were found to help explain the level of excess re turns over this period. Most in teres t ing was the f inding that there was a positive re la t ionship be tween free cash flow and the re turns accrued by the Japanese acquir ing firm. This f inding is contrary to past f indings for domest ic acquisitions.

The empirical work presen ted here helps explain why Japanese acquisi- t ions were so prevalent dur ing the 1980s. They also make the large p remiums offered seem much more ra t ional than they look in a relative sense when compared to p remiums offered by U.S. firms. It also refutes the conjecture offered by Wes ton et al. (1990) that these higher p remiums may be the result of a lack of familiari ty which in tu rn results in errors in sett ing the t ende r price.

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