Does the bidder’s takeover-induced leverage change affect its post-takeover long-term performance?

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Does the Bidder’s Takeover-Induced Leverage Change

Affect its Post-Takeover Long-Term Performance?

CHIA-HENG LEE

University of Amsterdam, Amsterdam Business School, the Netherlands Master in Business Economics, track Finance

Master Thesis

ABSTRACT

Why do the acquiring firms of a merger and acquisition fail to perform better in the long-term after the takeover? By analyzing 1,398 takeovers by US public bidders who reported their source of financing for their takeover payment, this paper seeks to find whether the leverage increased due to financing the takeover payment with debt affects the bidders’ post-takeover long-term performance. I find that bidders who need external financing for paying the takeover massively increases their leverage, and this “takeover-induced leverage change” has a significantly negative relationship with the bidders’ post-takeover long-term performance. I also find that the larger the leverage increases, the longer this negative effect influences the bidders’ performance after the takeover. The leverage burden impedes the bidder from exploiting the potential takeover synergies and makes them underperform.

Supervisor: Prof. Vladimir Vladimirov Date: July, 2014

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A takeover is an important event in a firm’s lifetime, and is perhaps one of the most important investments that a company would ever made. Many reasons can trigger the managers and the board to conduct a takeover. But no matter what the reason is, except for the managers’ interest of perquisite, it ultimately sourced from trying to pursue a better performance for the firm, either though the synergy created or the efficiency increased, or both. And for the board to approve a takeover investment, the board members must believe that the takeover can bring positive abnormal return to the shareholders. However, in the extensive research on bidders’ abnormal returns, only the bidders’ short-term announcement abnormal return could be positive in some circumstances. Almost every extant research focusing of long-term abnormal return report that the bidders do not perform better, and sometimes even worse in the long run. This is the well-known “takeover puzzle”, meaning that the bidder firms do not perform better after the expect-to-be-beneficial investment. But why is this the case? Researchers have been trying to find under what circumstances the bidders would underperform. Loughran and Vijh (1997), Rau and Vermaelen (1998), Datta et al. (2001), and Bruyland et al. (2013) find that bidders who pay by stock, who are highly valued (low book-to-market ratio), whose managers are paid by lower portion of equity-based compensation and who already performed badly before the takeover are followed by poorer stock performance. Therefore, we know that the firm and the bid characteristics affect the post-takeover performance of the bidders. However, these research mostly focus on bidder and target firm characteristic or deal characteristic, few of them focus on the fundamental changes of the bidders due to the takeover activity. These changes might be the actual drive for the bidders to underperform.

When a firm buys another firm, it pays by either equity or cash, or a mix of both. And when a firm choose to not pay by all-stock but by partial-cash or all-cash, it will have to finance for the cash part if it does not have enough free cash on hand. To finance for the cash part, the bidders can use either debt financing or equity financing, but either way their leverage level will change accordingly. This leverage change is then the “takeover-induced leverage change”. According to Martynova and Renneboog (2009)1, over 22.1% of all takeover events involve

1_{Martynova and Renneboog (2009) pg.1: “}_{…of the acquisitions entirely paid with cash (which stand for about 63% of all}

takeovers), one-third is at least partially financed with external funds. Seventy percent of the takeovers with external funding are financed with debt and 30% with equity. Of the firms opting to make an offer consisting of a combination of equity and

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debt financing. Also, when Malmendier, Moretti and Peters (2012) in their research find that bidders underperform three year after the takeover, they also find that this phenomenon is accompanied with substantial leverage increase shortly after the takeover complete. Could the debt/leverage increased after the takeover due to debt financing for cash be the reason for the bidders to underperform?

This paper aims to find the drive towards the underperformance phenomenon, and see if there is a way to avoid the underperformance by avoiding the drive. It re-examines the bidder firms’ post-takeover long-term performance from one year after the takeover to five years after the takeover and then examines whether the leverage change from the level before the takeover to the level after the takeover affects the post-takeover long-term performance. It also tries to analyze whether performance is affected by the leverage as long as the leverage changes, or is it only affected when this leverage change gets to a certain extend. Many research have documented the negative relationship between leverage and the future stock returns, and this relationship could be explained by Myers’ (1977) debt overhang theory. According to the theory, firms tend to forgo positive NPV opportunities due to the current interest burden from high debts, and thus they give up the opportunity to create value in the future. If it is also the case in the takeover context that bidders who financed their cash part of the bid tend to increase their leverage to a level that is too high, then it can be presumed that the debt overhang theory could also explain the post-takeover underperformance. I expect that the leverage increase due to financing for cash for the takeover bid leads to the bidder to underperform long-run after the takeover. I also expect that the more the leverage increase, the more the bidders suffer from debt overhang, and the longer they underperform than had they not conducted the takeover. If these expectations turn out to be true, then it should also be possible that debt-financed bidders underperform than internally or equity financed bidders, and bidders who pay by all-cash underperform than bidders who have payments with equity components, which contradicts to previous research.

I test these expectations by focusing on the US public bidders who reported their source of financing for cash part of their takeover payments. The sample is searched initially over the period of 1969 to 2013 from the Thomson One database. After necessary restrictions, the final sample contains 1,526 takeover observations between January 1985 and December 2012, of which 1,398 observations have complete post 1-year stock performance available, 1,132

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observations have complete post 2-years stock performance available, 942 observations have complete post 3-years stock performance available, 793 observations have complete post 4-years stock performance available, and 701 observations have complete post 5-4-years stock performance available. The leverage change is conducted by the average of the first four quarters’ leverage after the takeover effective date minus the last quarter’s leverage before the takeover effective date over the last quarter’s leverage before the takeover effective date in order to capture the significant leverage increase six months after the takeover documented in Malmendier, Moretti and Peters (2012). This leverage change is then split into quintile in order to examine the whether there are different effects toward the performance from different degrees of leverage changes. I then classify the bidders’ source of financing according to Vladimirov (2014), where bidders who financed with common stock, preferred stock, a rights issue and mezzanine financing are categorized as financing with non-debt, and bidders who financed with bridge loan, staple financing, junk bond offering, borrowing, line of credit, or foreign lender are categorized as financing debt. For those who finances without any of the above but with only internal corporate funds, they are categorized as purely internal financing. I also re-examined the performance difference between different payment method by classifying the bidders into all-cash and non-all-cash. To account for the post-takeover long-term performance, I use the buy-and-hold abnormal return approach (BHAR) that is also used by various research for long-term performance, with the benchmark firms be matched from the potential pool such that the sum of a benchmark firm’s absolute percentage differences for its pre-takeover 1 year (12 months) BHR, market capitalization, and book-to-market ratio between the bidder firm is minimized.

I find that, after controlling for other possible effects towards the post-takeover performance, the leverage increase due to the takeover has a significant and negative impact on the bidders’ post-takeover long-term performance. The result also shows that the larger the degree of the leverage increases, the longer the negative effect influences the performance. From the evidence presented, I also find that the negative impact from the leverage increase is transferred throughout the years after the takeover through the significant higher leverage than their benchmark firms, a leverage level that they could not effectively eliminate. The result is in line with the debt overhang theory such that the huge financial burden which caused by the interest obligation on bidder firms constraints them so much that they are not able to effectively extract the synergy from the takeover, and even not able to operate as well as had they not conducted the takeover. However, when comparing the bidders’ performance by their source

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of financing, I find that debt-financed bidders tend to outperform non-debt financed bidders in the first two years before they underperform from the third year onwards, but all not significant. When comparing the bidders’ performance by their payment method, all-cash bidders tend to outperform non-all-cash bidders throughout the five years after the takeover, which is in line with past research but contradicts with my expectation, although also all not significant. A possible explanation to this rather confusing result is that the negative signal conveyed by the bidders that their stock is currently overvalued is stronger when paying the whole takeover with equity than when paying with cash but only finance the cash part with equity, and also that both are more prominent than the effect of debt. The negative signal conveyed by equity payment therefore is more prominent than the debt overhang for a longer period, making equity payment bidders still underperform the cash payment bidders. And in the context of financing source, the negative signal conveyed by financing with non-debt is only more prominent than debt overhang for three years. From the fourth year onwards, the debt overhang is the drive for the bidders to underperform.

My research differs from previous studies in several ways. First, to my best knowledge, there is still no literature focusing on whether the post-takeover long-term performance is related to the debt and leverage increase due to the takeover itself. My findings adds to the knowledge on why the takeover bidders tend to underperform long-run after the takeover. Second, there is also very few literature that look into the performance difference between different source of financing, especially those focusing on longer terms such as five years after the takeover. Third, a special feature of my research is that I do not only focus on the performance in three or five years after the takeover as previous research normally do. Instead, I expand the examining horizon from one year to five years after the takeover. By this, I am able to inspect the development of all the factors that influences the performance throughout the years after the takeover. The contribution of this paper to extant literature is that it provides a possible explanation of the well-known “takeover puzzle” when the type of payment is not with 100% stock. It can also potentially provide a guide in practice for the bidders when deciding the way for financing the cash part of the bid. The research also provides an explanation to previous findings, such as why larger bidders tend to underperform compared to relatively smaller bidders.

The remainder of the paper is organized as follows. Section 2 introduces the related literature and develops my hypotheses. Section 3 describes the data collection and the sample

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generation, and introduces the methodology and the statistical regression model. Section 4 provides some description on the sample selected. Section 5 shows the empirical results. Section 6 provides some robustness check. Section 7 discusses the main findings and some limitations in my research, and Section 8 concludes.

2. Literature Review and Hypotheses

Takeover related literatures are in constant development since there are still many unsolved questions, especially in the field of the bidders’ post-takeover long-term performance. I divided this section into two parts. The first part discusses the previous takeover and capital structure literatures that are related to my research. And in the second part, I present the hypothesis that I formed according to the previous literatures, which are also the ones that I want to test in my research.

2.1 Related Literature

Corporate takeovers have been an intensively researched topic in the field of Corporate Finance. In such extremely complicated events, everything from the motivation of the takeover, the payment method, to the implementing process can affect whether the bidder be able to perform better after takeover in the short-term and long-term. Hence, many researcher started to focus on finding empirical evidence on this theme, and the factors that affects the bidder’s stock and operating performances.

However, a puzzling result revealed: although the bidders’ short-term announcement abnormal return can be positive in some circumstances, almost every past research reports that the bidders do not perform better, and sometimes even worse in the long run. In the following, I will first focus on introducing the works in the field of bidder abnormal return and post-takeover performance, and the works in the field of the effects of payment method and source of financing for cash bid to the bidders. Finally I will introduce the works which focus on explaining how debt/leverage is related to future stock return and how could it possibly be an explanation towards the “post-takeover puzzle”.

2.11 Takeover Gains and Post-Takeover Performance

Stock performance of both parties in a takeover event has been a topic of many scholars’ interests. The extant literature related to this topic can be divided into two fields: one is the bidder’s and the target’s short-term gain after their takeover announcement and the other is the

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bidder’s long-term abnormal performance after takeover is complete. Within the research on short-term gain, there is a reached consensus that target firms receive significant positive abnormal returns, but not for the bidder firms. In Betton et al. (2008), the authors conduct an overall test on the bidder’s gain under several conditions. They point out that the bidders’ size, the targets’ public status, the form for takeover and the payment method affects the bidders’ announcement gain. Their results are consistent with the more rigorous researches such as Loderer and Martin (1990) and Moeller, Schlingemann, and Stulz (2004) where they report that small bidders gain more than large bidders; Fuller, Netter, and Stegemoller (2002), Bradley and Sundaram (2006), Moeller, Schlingemann, and Stulz (2007) and Bargeron, Schlingemenn, Stulz, and Zutter (2007) where they report that bidders gain more when their targets are private firms than when they are public firms, and gain even more when they are subsidiaries; Yook (2003) and Betton, Eckbo, and Thorburn (2007) where they report that bidders gain more when the initial offer is a tender offer rather than a merger; and Yook (2003), Savor (2006), and Moeller, Schlingemann, and Stulz (2007) where they report that bidders gain significantly more when the payment method is in all-cash.

In contrast to the significance in the results from the bidder’s announcement period abnormal stock return, however, findings report from studies on the bidders’ long-run post-takeover stock performance are often not significant and show mostly underperformance. Moeller, Schlingemann and Stulz (2004) report insignificant 3-year post-takeover performance. By using the long-term buy-and-hold matched-firm technique, Loughran and Vijh (1997), Rau and Vermaelen (1998), Datta et al. (2001), and Bruyland et al. (2013) all show that the bidders’ stock underperform around 3 years after takeover. After looking closer, they suggest that the bidders who pay by stock, who are highly valued (low book-to-market ratio), whose managers are paid by lower portion of equity-based compensation and who already performed badly before the takeover are followed by poorer stock performance. Loderer and Martin (1990), by looking at the performance annually, find that there are usually negative performances during the first three years, especially between the second and the third year after the takeover. Malmendier, Moretti and Peters (2012), by benchmarking the winning firms with the losing firms in long contested takeover events, again provide support that the winning bidders significantly perform worse than their benchmark firms.

As previously mentioned, there is a well-known “puzzle” as to why do the bidders not perform better. Instead, they perform just as ordinary, or even worse. A research worth mentioning here is Loughran and Vijh (1997). By using the buy-and-hold benchmarking

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method and a post-takeover horizon of 5 years, they report that tender bidders earn on average more than their benchmarks while merger bidders earn less and all-cash bidders earn on average more than their benchmarks while all-stock bidders earn less, although both not significant. However when looking at bidders who conduct all-cash tender offers, they find significant stock return overperformance. The reason for tender offers to perform better than merger offers, they explain, is that merger offers are often mutual agreements between the two firms’ managers while in tender offers, bidders target the target firms’ shareholders directly. In this way, bidders can bypass inefficient managers who do not see the value of the takeover. It also often presents a higher bidder-confidence in the value generation of this takeover. This explanation is in line with the discovery of Martin and McConnell (1991). On the other hand, the reason for all-stock bidders to perform worse than all-cash bidders, they claim, is the signalling effect in capital structure theories.

2.12 Payment Method, Source of Funding for Cash, and Bidder’s Gain

When a firm is to buy another firm, it can pay by either equity or cash, or a mix of both. From past research, how the bidders decide to pay depends on various factors such as taxes, asymmetric information among parties, capital structure and corporate control motives and behavioural motives. In a recent paper, Vladimirov (2014) provides evidence that the bidders’ ability to access competitive capital market endogenously affects the choice of payment method, and the source of financing once a cash bid is decided. These motives influence the decision of paying with all-cash or all-stock or the percentage of each. As previously mentioned, the payment method affects the bidders’ stock performance, either in announcement period or in long-term post-takeover period. This aspect has also been intensively researched in extant literatures. For example: Wansley, Lane, and Yang (1983, 1987), Asquith, Bruner, and Mullins (1987), Travlos (1987), Franks, Harris, and Mayer (1988), Brown and Ryngaert (1991), Servaes (1991), Emery and Switzer (1991), Smith and Kim (1994), Martin (1996), and Heron and Lie (2004) and much more. These research have a consensus that all-stock bidders tend to earn negative abnormal announcement return while all-cash bidders tend to earn positive announcement abnormal return, but the explanations are divergent. There are mainly two explanations, one is the signalling effect, and the other is the benefit of debt effect.

In the theory of signalling effect, it argues that paying with stock for a takeover is similar as issuing new stocks. In the world where the bidder managers normally possess more information than the market, investors consider the firms who issue equity as releasing

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information that their stocks are currently overpriced. Hence the market reacts in a negative way. In contrast, under the same state of world, the market views the bidders who pay by all-cash do so because they are unwilling to use currently-undervalued stock as a currency to pay. Therefore the market reacts in a positive way. This argument is supported by Myers and Majluf (1984). The other theory is the benefit of debt effect. When a bidder decide to pay by cash, it has to find a way to finance the cash. According to the pecking order theory, the bidders will first take out their internal funds and then finance the cash bid with debt. The bidder therefore receives the debt benefits. There are three sources of debt benefits, which are tax shields, reduction in the agency costs, and wealth transfer. Among those, reduction in the agency costs due to debt has been emphasized as a primary explanation for better stock performance in announcement period studies for cash bids. A group of researchers such as Jensen (1986, 1988), Harris and Raviv (1990), and Stulz (1988), Jensen and Meckling (1976), Grossman and Hart (1982) all document the benefit and effectiveness of reducing agency cost with more debt by agreeing that debt constrains bidder managers to make decisions that are more in line with the shareholders. There are three main arguments: first, the bidder manager will be constraint to make more sedate management decisions and not invest in negative NPV project, such as perquisite, because they have to fulfil the interest agreement regularly with the financier; second, managers in high levered firms must face a higher probability of bankruptcy, therefore they are forced to work harder to maintain the operation of the firm; third, since the managers have to meet the interest payment to the financier, the financier undertakes a monitoring function which common shareholders cannot easily have, and this monitoring function restricts the manager to not use excess free cash flow on perquisites rather than positive NPV projects or return to shareholders.

In Yook’s (2003) research on why all-cash bidders perform better during announcement period, he uses the Standard and Poor’s debt rating review as the proxy for debt benefit. He divide the all-cash bidders into three groups: the ones whose debt rating got upgraded, unchanged, and downgraded. The result show that for the group of unchanged debt rating, the announcement return is significantly negative, but for the group of downgraded debt rating, the announcement return in insignificantly negative, and is significantly larger than the unchanged group’s announcement return. He interprets the result as supportive to the debt benefit theory because a downgrade in the rating means that the benefit of debt is effective, and the bidders who perform the best within all-cash bidders are the ones whose debt get downgraded. This phenomenon is especially prominent when a bidder has excess free cash flows, where the

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benefit of debt in reducing agency cost can be exerted to the most due to the potential managerial perquisite with the excess free cash flows. Maloney, McCormick, and Mitchell (1993) also research on the effectiveness of debt in reducing agency costs in all-cash bidders. They find that both the pre-announcement leverage level and the pre- and post-takeover leverage change are positively related to the announcement abnormal stock return. They also find that the more the leverage is increased because of the takeover, the higher the announcement abnormal return. They explain that this is due to that market believes the bidder manager is making the best decision for the shareholders because of the high debt acting as a monitor. However, Yook (2003) find that the signalling effect is only prominent in all-stock bid but in all-cash bids the value drive is mainly the benefit of debt. Therefore the explanation that the signalling effect is the main value drive for all-cash bids in Loughran and Vijh (1997) might be in question. Another important research by Martynova and Renneboog (2009), who look exclusively into the source of financing for cash part of the bid, also find a significant negative price reaction for not only equity bids but also for equity-financed cash-bids, and a significant positive stock reaction around announcement period when cash bids are financed with debt. They again attribute the negative stock reaction to the signalling effect and the positive reaction to one of the benefit of debt as well as the signalling effect.

All in all, the benefit of debt caused by the increase in debt/leverage has been the explanation that is used so far for the positive short-term announcement return for all-cash payment bidders. However, as was said in Maloney, McCormick, and Mitchell (1993): “…however, the results should not be interpret as the value of a firm will increase as the firm increases leverage. They merely say that agency costs do exist, and the debt benefit followed by increase in leverage helps mediate or alleviate them.” Therefore, when extending the time horizon into a longer term, whether the benefit of debt still exists and outweighs the potential cost of debt, and the effect of debt to long-term post-takeover stock performance is still an unsolved topic.

2.13 Debt, Leverage and Future Stock Return

In Malmendier, Moretti and Peters (2012), in addition to finding evidence that bidders underperform long-run post-takeover, they also find that although the underperformance is robust after controlling for the payment method, it is more prominent in cash financed mergers, and also find out an interesting phenomenon that winning bidders’ underperformance is accompanied with substantial leverage increase 6 months after the takeover complete, and also

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that the leverage continues to increase and diverge with the benchmark firms. They claim that the traditional way of finding the benchmark firms with book-to-market ratio and size can cause bias, and that their way of benchmarking leads to more accurate results. Yet another question is that whether increase in leverage due to the takeover may be the cause of the underperformance.

In theory, leverage has been considered as a source of financial risk to a firm. Half a century ago, the noted Modigliani and Miller (1958; henceforth MM) present that the firm value is not related to its capital structure, and in their preposition II, they present that for a firm who has debt in its capital structure, its return rate on common stock is the return rate for pure equity plus a premium related to financial risk. From this argument, future stock return should be positively related to financial risk, and hence to the leverage level. However, the assumptions that MM used were deemed to hold only in a perfect world and are not realistic in the real world. Therefore, scholars such as Lintner (1956) and Gordon (1959) present that there should be an optimal leverage level where the benefit of debt (such as tax shields) and the cost of debt (such as increase in expected bankruptcy cost) balance.

In fact, empirically, whether debt/leverage has positive or negative impact on future stock return has been another widely researched topic, and until now already half a century has passed after MM, still no consensus has been reached. Some researchers found that future stock returns increase as leverage increase (Hamada, 1972; Baker 1973; Bhandari 1988), but most researchers report a negative relationship between leverage and future stock returns (Arditti, 1967; Hall et al., 1967; Korteweg, 2004; Dimitrov and Jain, 2005; Penman, Richardson and Tuna, 2007; Muradoglu and Sivaprasad, 2010; Cai and Zhang, 2010; Kose, 2011; Caskey, Hughes and Hu, 2012). In Muradoglu and Sivaprasad (2010), the authors argued that the sample used in MM to conduct empirical test was only in the utility and oil/gas industry and was not representative enough. They expand MM and test the relationship between leverage and future stock return on firms in every risk class as well as using more modern measure of return and leverage. They find that although in the utility sector, future stock return is still positively related to leverage, but for the firms in other sectors and the overall sample, this relationship is negative. This result implies that whether the relationship between leverage and future stock return be negative or positive is dependent on the industry that the firm is operating in. In Cai and Zhang (2010), they research on the effect of increase in leverage towards the future stock return. They find that increase in leverage has a significantly negative effect to future stock return, and the result stays robust after controlling for firm specific characteristics

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and risk factors. They also found evidence that an increase in leverage is associated with lower future real investments.

Overall, from extent literature, we see that the effect of leverage or leverage change towards future stock return is still not very clear, but they tend to point out a negative relationship. As previously discussed, there are three sources of debt benefits, which are tax shields, reduction in agency cost, and wealth transfer. However, there are also commonly argued cost of debt such as underinvestment, asset substitution, and the increased probability of bankruptcy. While debt could act as a constraint towards managers against perquisite, they might put so much constraint that managers become inflexible in future opportunities. Harris and Raviv (1991) argue that leverage impedes management in that leverage makes the managers less able to compete effectively because they have to focus on meeting interest payments.

Cai and Zhang (2010) gives explanations to their findings with the Myers’ (1977) debt overhang theory. This theory says that the higher the leverage level, the higher the possibility that a firm forgoes positive NPV projects. It is because that the high interest burden followed by high debt will make the manager more risk averse, making the manager require a premium. Also after accounting into the debt obligation, the payoff of an investment will be lower than what the initial investors invested. As a result, when a positive NPV project is presented, the managers tend to forgo the project, resulting in underinvestment. This underinvestment reduced the value growth opportunity for a firm. Hence, the higher the leverage level may result in lower future stock return. Researchers such as Aivazian et al. (2005) and Ahn st al. (2006) tested this theory by examine the relation between leverage and future investment and growth directly. The discoveries are supportive to the debt overhang theory.

2.2 Hypothesis Formation

Previous studies on the relationship between leverage and future stock return all set a time range of at least one quarter. Therefore it is logical that in the short term period such as announcement period, the market reacts positively due to the reduction of agency cost. However in the longer period, the costs of debt might outweigh the benefits of debt and become the dominant drive towards the longer term stock return. As mention above, a more recent research by Malmendier, Moretti and Peters (2012) discovered that winning bidder’s underperformance is accompanied with substantial leverage increase 6 months after the takeover complete. Quite a few literatures such as Cai and Zhang (2010) have documented the

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negative effect of increase in debt/leverage towards the future stock return. In addition, the debt overhang theory also predicts that the higher the leverage level, the more the firm is to suffer from debt overhang. Together, I formulate the hypothesis that:

Hypothesis 1: The leverage increase due to financing for the cash part of the takeover bid leads to the bidder to underperform long-run after takeover. And the more the leverage increase, the longer the effect last.

There is also another phenomenon presented in Malmendier, Moretti and Peters (2012) that the bidders’ leverages continue to increase and diverge with their benchmarked firms. Since most of the extend literatures such as Penman, Richardson and Tuna (2007) document that leverage level is negatively related to future stock return rather that future abnormal stock return, it is reasonable to presume that the underperformance is caused by that bidders having too much more leverage compared to their benchmark firms’, and therefore leads to the bidders’ long-term return to perform worse than their benchmark firms’ long-term return. Thus, I formulate my second hypothesis that:

Hypothesis 2: The post-takeover underperformance is result from that bidders tend to make themselves suffer from significant higher debt/leverage than had they not conducted the takeover (the counterfactual).

Apart from proposing that leverage might be the reason for bidders to underperform, Malmendier, Moretti and Peters (2012) also discovered that although the underperformance is robust after controlling for the payment method, it is more prominent in cash takeovers. Taking into account that cash bidders often increase leverage due to financing, as well as predicted by Vladimirov (2014) that after endogeneizing the financial constraint, all-cash bids often pay a higher takeover price than equity bids, a possibility that leads to underperformance due to overpayment, I assume that:

Hypothesis 3: After endogeneizing the choice of payment method by financial constraint, in the long run, all-cash bids should perform worse than bids with equity components.

Looking closer, among all the cash bidders, those who financed with debt are more prone to suffer from the possible cost of debt in the long run after debt/leverage increases. Again combine with the prediction in Vladimirov (2014) that bidders who finance cash part of bid

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with debt will pay a highest takeover price compare to other sources of financing, I thus formulate my last hypothesis:

Hypothesis 4: After endogeneizing the source of financing for cash part of the takeover payment with financial constraint, in the long run, bidders who financed their cash part of the bid with debt should perform worse than those who financed with equity.

To test these hypothesis, one should conduct an empirical study in which the benchmarking method is different from past literature such as Loughran and Vijh (1997), but has a similar benefit as the method used in Malmendier, Moretti and Peters (2012).

3. Methodology and Research Design 3.1 Takeover Sample

The takeover sample is searched from the Thomson One database for takeover information from the period of January 1961 to December 2013. The following initial requirements are applied to the sample: (1) the information for the source of financing for the cash bid is available; (2) the bidders are US firms; (3) the bidders are publicly quoted firms; (4) firms, the bidders or the targets, which are in the financial industry (US SIC code 6000-6999) and highly government regulated firms (UC SIC code 4900-4999) are excluded; (5) the bidders have final stakes of more than 50% in the target firms after the takeover. This initial search of sample results in 5,412 takeover observations from 1985 until 2013.

Stock and return information are acquired from the CRSP Monthly Stock Database. The quarterly fundamental financial information is acquired from the COMPUSTAT Fundamental Quarterly Database. I further drop the bidder firms who do not have complete stock information one year before the takeover effective date and who do not have complete fundamental information one quarter before the takeover effective date. If a bidder performed multiple takeovers within the sample period, only the most recent one and the ones which have at least 12 months until the next takeover are kept in the sample in order to rule out problems such as looking-forward bias, calendar clustering and overlapping returns. Bidders with non-positive book values of equity during the period one year before and five years after the takeover effective day are also dropped since these firms have extreme leverage ratios that can be less than zero or more than one. Finally, all bidders are assigned an industry according to the industry category used in Fama & French (1997) by US 4-digit SIC code (acquirer primary SIC). The Fama & French (1997) industry category is shown in Appendix I. The final sample

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contains 1,526 takeover observations between January 1985 and December 2012, of which 1,398 observations have complete post 1-year stock information available, 1,132 observations have complete post 2-years stock information available, 942 observations have complete post 3-years stock information available, 793 observations have complete post 4-years stock information available, and 701 observations have complete post 5-years stock information available. See the next section for the more detailed description of the sample. .

3.2 The Leverage

The total debt leverage is used as the leverage in this research to capture the effect of debt increase. The total debt leverage is calculated by the total debt (sum of short-term and long-term debt) over the total asset. Market leverage is not considered since it is mechanically related to the stock performance, therefore the abnormal return. The leverage difference is calculated by the bidders’ average leverage level of the four quarters in the nth year after the takeover minus that of the benchmark firms (the counterfactual). All the fundamental data are downloaded from the COMPUSTAT on a quarterly bases.

The change in leverage is presented by the average of the first four quarters’ leverage after takeover effective day minus the last quarter’s leverage then divided by the last quarter’s leverage before takeover effective day. The reason for taking post- one year average of leverages is that in Malmendier, Moretti and Peters (2012), thy find that the leverage increases significantly 6 months after the takeover. Taking average of post- one year of the data, rather than merely using the change of pre- and post- one quarter can capture this phenomenon. The changes in leverages are winsorized by 5% level and are split into quintiles, with the lowest quintile in q1 and the highest in q5.

3.3 The Source of Fund

According to Vladimirov (2014), issues in common stock, preferred stock, a rights issue and mezzanine financing are categorized as financing for cash with issuing equity (non-debt). If the source of fund is one of the following: bridge loan, staple financing, junk bond offering, borrowing, line of credit, or foreign lender, then it is categorized as financing for cash with debt. The source of financing is categorized into three groups. The first group are the bidders whose cash bids are financed with pure non-debt, pure non-debt with internal funds, or mixed of non-debt and debt and internal funds. The second group are the bidders whose cash bids are financed with pure debt or pure debt with internal funds. If a bidder finances the cash without any of the above but with only corporate funds, then it is categorized in the third group as

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3.4 The Long-Run Post-Takeover Performance

The method that is widely used to measure the post-takeover long-term performance in extant research is the buy-and-hold abnormal return technique, also known as the BHAR approach. The intuition of this method is to buy the merged firms’ stock and sell the counterfactual benchmark firms’ stock at the same time and hold for a certain period of time, and the profit is the abnormal return due to the takeover.

𝐵𝐻𝑅𝑖 ≡ [∏(1 + 𝑅𝑖𝑡) − 1 𝑇

𝑡=1

] × 100 (%)

Performance = 𝐵𝐻𝐴𝑅𝑏𝑖𝑑𝑑𝑒𝑟≡ 𝐵𝐻𝑅𝑏𝑖𝑑𝑑𝑒𝑟− 𝐵𝐻𝑅𝑏𝑖𝑑𝑑𝑒𝑟′𝑠 𝑏𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝑓𝑖𝑟𝑚

The BHR in equation (1) is the cumulative return of buying a firm’s stock. Rit denotes the stock return to firm i over period t. Ti denotes the total holding period for stock i. The performance in equation (2) denotes the BHAR that measures the bidder’s long-term abnormal stock return. If the performance is positive, it implies that a bidder’s stock performs better than had it not conducted the takeover, therefore an overperformance. And if the performance is negative, it implies that a bidder’s stock performs worse than had it not conducted the takeover, therefore an underperformance. In this paper, the BHR is calculated starting from the first day of the month right after the takeover effective date, and the stock return is cumulated monthly.

The BHAR approach involves comparing a bidder firm’s long-term return to a benchmark firm’s long-term return that represents the counterfactual. Yet, the selection of a benchmark firm that is representative enough has always been a problematic issue when implementing this method. The more general and typical way of searching for a benchmark firm is to match with size and book-to-market ratio, and sometimes with industry. However Rau and Vermaelen (1998) and Bruyland et al. (2013) provide evidence that pre-takeover performance can also affect post-takeover performance, making the result using only size and book-to-market ratio biased. Malmendier et al. (2012) also support this by showing that “…the winner’s and loser’s performance prior to the takeover contest closely track each other.” Therefore, in this paper I implemented the benchmarking method used by both Detta et al. (2001) and Bruyland et al. (2013). I select a bidder’s benchmark firm from the potential benchmark firm pool such that the sum of a benchmark firm’s absolute percentage differences for its pre-takeover 1 year (12

(2) (1)

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(3)

months) BHR, market capitalization, and book-to-market ratio between the bidder is minimized. This matching procedure can eliminate the potential bias from the unobserved differences between bidders and benchmarks, according to Bruyland et al. (2013). The pre-one year BHR is calculated from the month before the takeover effective month and then cumulated 12 months backwards. The market capitalization, representing the size, and the book-to-market ratio, calculated as the book value of equity over market value of equity, are compared at the end of the month prior to the takeover effective date.

The pool of potential benchmark firms are the firms that are listed in the CRSP Monthly Stock Database in the sample period excluding the sample firms. The firms whose pre 1 year BHR, pre 1 month market capitalization and pre 1 month book-to-market ratio are not available are excluded from the pool. The firms who have conducted a takeover event within 3 years before the takeover effective month are also excluded from the pool. If a benchmark firm does not have complete BHR available for post 1 to 5 years, the value-weighted market return in the CRSP Monthly Stock Database is used to continue calculating the BHR. According to Lyon et al. (1999), using the value-weighted market return rather than replacing with another benchmark firm will not significantly affect the calculation of the bidder’s abnormal performance.

3.5 Statistical Model

To test for whether the change in leverage and the leverage difference between bidders and their benchmarks have causal effects on the bidders’ long-term post-takeover performance, and whether the source of financing for the cash part in the payment is debt has a correlation with the bidders’ long-term post-takeover performance, I employ the following OLS regression models: 𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒 = 𝛼 + 𝛽1𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑖+ ∑ 𝛽𝑘𝑖𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑞𝑢𝑖𝑛𝑡𝑖𝑙𝑒𝑘𝑖 5 2 + 𝛽6𝑑𝑒𝑏𝑡𝑖 + 𝛽7𝑃𝑢𝑟𝑒𝑖𝑛𝑡𝑖+ 𝛽8𝑎𝑙𝑙𝑐𝑎𝑠ℎ𝑖+ ∑ 𝛾𝑖𝑊𝑖 8 1 + 𝑦𝑒𝑎𝑟 𝑓𝑖𝑥𝑒𝑑 𝑒𝑓𝑓𝑒𝑐𝑡𝑠 + 𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑓𝑖𝑥𝑒𝑑 𝑒𝑓𝑓𝑒𝑐𝑡𝑠 + 𝜇𝑖

Where leverage difference is the difference between a bidder’s leverage and its benchmark’s leverage, defined as bidder leverage minus benchmark leverage. The leverage change quintile are dummy variables that denote the quintile of the percentage change in

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leverage as previously defined. To illustrate, Q2 equals 1 if the percentage leverage change is between the 20% and 40% percentile, Q3 equals 1 if percentage leverage is between the 40% and 60% percentile, and so forth. Debt is the dummy variable that equals to 1 if the source of financing is grouped as debt and 0 if otherwise. Pureint is the dummy variable that equals to 1 if the source of financing is purely internal funds and 0 if otherwise. Allcash is the dummy variable that equals to 1 only if the method of payment is in all-cash and 0 if otherwise. According to my hypothesis, the expected sign of the coefficient of leverage difference should be negative. The expected sign of the coefficient for the leverage change quintile should also be negative, and the effect should be stronger for the higher quintiles. Also according to my hypothesis, the coefficient for debt and allcash should be negative after controlling for financial constraints.

The regression model is then controlled with 8 firm and takeover characteristics that are proved or suggested to affect post-takeover long-run performance in extent literatures. I first control for several bidder characteristics, including the bidders’ size, the bidders’ pre-takeover MTB ratio and the bidders’ financial constraint. In Moeller, Schlingemann, and Stulz (2004), Harford (2005) and Betton et al (2008), the authors suggest that larger firms tend to underperform post-takeover. I use the natural logarithm of pre-takeover 1 quarter total asset to account for the bidders’ size, the size. Rau and Vermaelen (1998) find evidence that bidders who are highly valued (high MTB ratio) prior to takeover tend to underperform after takeover. I include the pre-takeover 1 month MTB ratio, calculated by the market capitalization in the previous month over the total asset in that month, to control for this effect. Last is this category, I control for the bidders’ financial constraint. According to Vladimirov (2014), bidders’ financial constraint is one of the factors that affect how the bidders choose for their payment and the source of financing. Some of the past literatures also suggested that a firm’s financial constraint may be related to its future stock return (Lamont et al., 2001). The factors that influences a firm’s financial constraints are the market that it operates, size, public status and its age. Since in my sample selection, the bidders are already public US firms, and that size is already controlled, I added the bidder firm’s age which is the number of years that the firm is public, defined as the current year minus the first year that the firm has a non-missing stock price on the Compustat database, as an additional control.

I then control for two offer characteristics, the offer type and the attitude of the takeover. In Rau and Vermaelen (1998), Loughran and Vijh (1997), Jensen and Ruback (1983) etc., they all suggest that when the offer type is a tender offer, the bidders perform better than when the

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offer type is a merger offer. I thus include a dummy variable tender that equals 1 if the offer is a tender offer and 0 if the offer is otherwise. I also control for the bid attitude since it has been suggested that whether the bid attitude is hostile or friendly affects the post-takeover performance. Hostile takeovers are considered to perform worse that friendly takeovers since they might need to overpay to successfully takeover the target firm, and the initial motivation for a bidder to conduct a hostile takeover might not be for the good of the combined entity. I include a dummy variable hostile that equals 1 if the attitude is hostile and 0 if the attitude is otherwise.

Finally, I control for the targets’ characteristic and the relationship between the bidders and the targets. Studies such as Morck, Shleifer, and Vishny(1990) and Tuch and O’Sullivan (2007) have shown that takeover synergies are more likely to realize and create value if the bidder and the target are operating in similar businesses, and the post-takeover performance are worse when the bidder tries to diversify. Therefore, I include a dummy variable diverse which equals to 1 if the bidder and the target are in different Fama & French (1997) industries and 0 when they are in the same industry. Also, the targets’ public status has been widely proven to be related to bidders’ post-takeover performance (Fuller, Netter, and Stegemoller, 2002; Bradley and Sundaram, 2006; Moeller, Schlingemann, and Stulz, 2007; Bargeron, Schlingemenn, Stulz, and Zutter, 2007; Betton et al., 2008). Bidders perform better when the target they takeover are private firms than when the target are public firms. A dummy variable target public is included and is equal to 1 if the target is a public firm and 0 if the target is otherwise. Last, I control for the relative deal size to the bidder. Researcher such as Asquith (1983) finds that when the target is relatively larger than the bidder, the synergy from the takeover is more likely to be realized. I include the variable relative deal size, measured as the transaction value over the bidder’s market capitalization 1 month end before the effective date, which is also used in Malmendier et al. (2012) to capture this effect.

4. Sample Description

The takeover sample are drawn from the Thomson One database for completed takeover information. After initial filters and necessary arrangements, the final sample consist of 1,526 takeover observations during the period of January 1985 and December 2012. Of which, 1,398 observations contains complete post-one-year BHR, 1,132 observations contains complete post-two-years BHR, 942 observations contains complete post-three-years BHR, 793 observations contains complete post-four-years BHR, and 701 observations contains complete

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post-five-years BHR. Table I summarizes the takeover sample. Panel A of Table I shows the takeover observations by takeover effective year, bidders’ industry, method of payment and the source of financing for cash part of the bid. In Panel A-1, although I restricted my sample into only those who reported the source of financing, the number of observations across the years presents a trend that is align with past research. There is a significant takeover increase during the late 90s that stopped because of the end of the dot-com bubble, and another significant takeover increase during the mid-2000s that ends when the US subprime bubble burst at 2008. From 1985 to 2010, there are on average 20% of the firms in each takeover year unable to survive until the third year, and from 1985 to 2008, there are on average 34% of the firms in each takeover year unable to survive until the fifth year. Panel A-2 shows the takeover observations by the Fama Fench (1997) industry category. The top five majority of the deals are in the business service, petroleum and natural gas, electronics, retail and machinery industry, which is also in line with previous research.

Panel B shows the takeover observations by the payment method and the source of financing and how they are related. Under the selection of where the source of financing must be available, the vast majority of the payment method are all cash offers and mixed payments. Panel B also shows that under such selection of sample, the vast majority of the takeover are finance with debt or debt with internal funds, indicating that most of the takeovers that have cash components and need external financing choose to finance with debt. Looking at how the source of financing is related with payment method, as shown in Panel B, when a bidder choose to pay by all-cash or a mix of both cash and stock and need external finance, they tend to go for debt financing instead of equity. There are quite some bidders who financed by pure internal funds, but are relatively rare since rarely does a bidder have sufficient cash on hand to fully finance a takeover and also since by doing so it conveys a negative signal that the bidder manager is hunting for perquisite.

Panel C shows the comparison of the buy-and-hold return (BHR) and the leverage throughout 1 year before the takeover and 5 years after the takeover between the sample bidder firms and their benchmark firms. Due to the criteria for searching the benchmark firms, the BHR of the bidders and the benchmark firms 1 year before the takeover are almost the same, ranging from around -12% to 42% with the averages at about 22%. However throughout the five years after the takeover, the bidders’ average BHR are generally smaller than the benchmark firms’ average BHR, despite the fact that both bidders and the benchmarks have positive and growing BHRs and comparable standard deviations. This indicates that the bidders

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underperform during the long-run. The difference of the average leverage between bidders and benchmarks one year before the takeover is about 3%, which is almost the same as reported in Malmendier, Moretti and Peters (2012) (about 2%). After the takeover, the benchmark firms maintain a quite even leverage level throughout the post-five-years. However, the leverage level of the bidders dramatically increase one year after the takeover and then gradually decrease, although still higher than pre-takeover level. The bidders leverage level range between 20% and 40%, generally higher than the benchmark firms leverage level, which range between 17% and 35%. This indicates that the bidders’ underperformance might be due to their leverage change induced by the takeover. The significance of the differences between BHRs and leverages are reported and discussed in the next section.

Panel D shows the distribution of the leverage change, reported in total and in quintile. The leverage change is winsorized by 5 %. In total, the mean percentage change of the leverage is about +49% with median at about +13%. Looking at the quintiles, the mean leverage change in the lowest quintile is -20.3% and +208% in the largest quintile, but the mean in the third quintile only +14%. This obvious positively-skewed distribution indicates that the bidders tend to increase their leverage for the takeover, and that the increment is quite significant with about one-fifth of the bidders almost doubled or even tripled their leverage compared to pre-takeover level. Panel E shows the number of observations for each leverage change quintile by the payment method and the source of financing. As shown in the table, almost 50% of the debt financed bidders increase their leverage over +25% due to the takeover. Even for non-debt bidders who pay by all-cash, also almost 50% of the bidders increase their leverage over +25%. Pure internal financed bidders however, over 50% of them do not change or even decrease their leverage due to the takeover. In the next section, I will present the main results of the empirical tests to my hypothesis.

5. Empirical Results

5.1 Payment Method, Source of Financing and Post-Takeover Long-Run Abnormal Returns

In this part, I first examine the post-takeover long-term performance for the overall sample, and then examine the performance further for the subsample of different payment methods, different source of financing, and different leverage change quintile. The buy-and-hold return for both the sample firms and the benchmark firms and the sample firms’ buy-and-hold abnormal return, measured by the average difference between the buy-and-hold returns for the

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sample firms and the benchmark firms are reported in Table II. Panel A in Table II shows that in the overall sample, on average, the bidder firms’ buy-and-hold return are +8.31%, +15.36%, +27.62%, +40.96% and +54.76% compared to +11.58%, +23.8%, +38.02%, +53.37% and +69.60% for the benchmark firms’ throughout the five years after the takeover. The differences are -3.27%, -8.44%, -10.41%, -12.41% and -14.84%, which are all significant by at least 10% level and are gradually decreasing. This evidence once again shows that the bidders on average underperform long-run after the takeover, as is already frequently reported in extant literatures. The underperformance at the post-three-year is -10.41%, which is slightly lower than past literatures who used the same criteria form searching benchmark firms (Detta et al., 2001 and Bruyland et al., 2013, both reported underperformance around -9.2% to -9.3% for the third year after the takeover). This may be because my sample is slightly more negatively biased compare to previous research due to the fact that the firms who reported their source of financing are mostly debt financed bidders who tend to increase their leverage due to takeover, and also tend to underperform according to my hypothesis. Panel B in Table II shows the bidders’ and their benchmark firms’ buy-and-hold returns and their differences by whether the payment is in all-cash or having equity components. For all-all-cash bidders, reported in Panel B-1, the buy-and-hold return for the post-five-years are +9.74%, +16.21%, +32.03%, +48.33%, and +60.52% while their benchmark firms’ buy-and-hold return are +13.1%, +26.28%, +41.75%, +61.76%, and +75.89%. The differences throughout the five years are -3.36%, -10.07%, -9.71%, -13.43%, and -15.37%, significant only in under 20% level except for the second year. For bidders who pay a mix of both cash and equity, reported in Panel B-2, the buy-and-hold returns for the post-five-years are +7.39%, +14.82%, +24.90%, +36.62%, and +51.35% while their benchmark firms’ buy-and-hold return are +10.6%, +22.22%, +35.73%, +48.43%, and +65.88%. The differences for nonallcash payment bidders throughout the five years are 3.21%, 7.4%, -10.83%, -11.81%, and -14.53%, also significant only under 20% level except for the second and the third year. Comparing the two types of bidders, the all-cash bidders seem to perform on average worse than bidders having equity components, with the difference of 0.37%, -2.99%, 1.56%, -2.74%, and -3.59% (t-statistics -0.10, -0.48, 0.18, -0.22, and -0.22). However, the differences are not significantly different from zero and the sign flipped at the third year after takeover. Therefore from this univariate evidence, it is not clear whether all-cash bidders perform worse than bidders with equity components.

Panel C in Table II shows the bidders’ and their benchmark firms’ buy-and-hold returns and the differences by the bidders’ source of financing for cash. For non-debt financing bidders,

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reported in Panel C-1, the buy-and-hold return for the post-five-years are +7.46%, +13.81%, +22.59%, +59.07%, and +47.82% while their benchmark firms’ buy-and-hold return are +14.17%, +31.71%, +44.85%, +64.42%, and +58.93%. The differences throughout the five years are -6.71%, -17.9%, -22.26%, -5.35%, and -11.12%, only significant under 20% level for the second year and the third year. For debt financing bidders, reported in Panel C-2, the buy-and-hold return for the post-five-years are +7.00%, +13.92%, +24.27%, +35.67%, and +50.54% while their benchmark firms’ buy-and-hold return are +10.89%, +23.91%, +37.73%, +53.68%, and +70.68%. The differences throughout the five years are 3.89%, 9.98%, -13.46%, -18.01%, and -20.15%, all significant under at least 10% level and under 1% level for the second year and the third year. For pure internally financed bidders, reported in Panel C-3, the buy-and-hold returns for the post-5-years are +13.35%, +21.21%, +41.95%, +52.95%, and +75.36% while their benchmark firms’ buy-and-hold returns are +12.88%, +19.89%, +36.02%, +47.61%, and +70.37%. The differences throughout the five years are -0.47%, -0.20%, -0.55%, -0.35%, and -0.22% and not significantly different from zero. The evidence show that there is no significant abnormal returns for the bidders who finance their cash completely with internal funds.

Compare the debt financing bidders and the non-debt financing bidders, the former seem to perform better in the first three years after takeover but turn to perform worse after the third year. The possible explanation to this could be that the negative signaling effect for financing with equity is alleviated only after three years after the takeover. Research such as Loughran and Ritter (1995) and Spiess and Affleck-Graves (1995) report that firms who made secondary equity offering underperform their benchmark firms for about a five-year period. In fact, looking at the patterns of average buy-and-hold abnormal returns for both debt-financed bidders and non-debt-financed bidders, the BHAR for debt-financed bidders has a steady and significant downward trend, whereas the BHAR for nondebt financing bidders jumped from -22.26% to -5.35%. This jump is not due to a lower growth for benchmark firms (steady BHR growth about +40%) but rather a sudden high growth for the bidder firms (about +160% from year three to year four compared to about +60% from year two to year three). This further supports that within a post-three-year period, the market overreacts to the signals convey by the choice of financing source and that in the longer run, debt-financed bidders should perform worse than non-debt-financed bidders due to the debt constraints.

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Panel D of Table II shows the bidders’ and their benchmark firms’ buy-and-hold returns and their differences according to the bidders’ leverage change quintile. In the first quintile where leverage decreases, reported in Panel D-1, the bidder firms on average perform better than their benchmark firms. The differences between the bidders’ and their benchmark firms’ buy-and-hold returns throughout the five years are +13.67%, +11.71%, +13.62%, +23.44%, and +17.57%, significant under 1% level in the first year after takeover and at least 20% level throughout the second to the fifth year. In the second quintile where the distribution contains zero, reported in Panel D-2, the differences between the bidders’ and their benchmark firms’ buy-and-hold returns are +3.26%, -1.89%, +1.87%, +7.5%, and -7.64% for the post-five years, which are ambiguous and insignificant. Therefore when the leverage change is within about ±5%, there is no significant abnormal return for the bidder firms. In the third quintile, reported in Panel D-3, the differences between the bidders’ and their benchmark firms’ buy-and-hold returns are -9.73%, -18.88%, -8.42%, -5.6%, and -10.02% for the post-five years and are significant under at least 5% level for the first two years. In the fourth quintile, reported in Panel D-4, the differences between the bidders’ and their benchmark firms’ buy-and-hold returns are -13.01%, -19.86%, -33.23%, -31.88%, and -30.65%, all significant throughout the five years after the takeover under at least 10% level. And last in the fifth quintile, reported in Panel D-5, the differences between the bidders’ and their benchmark firms’ buy-and-hold returns are -8.21%, -16.1%, -22.78%, -40.05%, and -28.94%, also all significant throughout the five years after the takeover under at least 10% level except for the fifth year. In the third to the fifth quintile where the leverage increases, the bidder firms perform worse than their benchmark firms, and the upper the quintile, the longer the significance of the underperformance lasts. The degree of underperformance also becomes larger the upper the leverage change quintile. (Although the bidder firms in the fifth quintile seem to perform slightly better than the firms in the fourth quintile, the differences are insignificantly different from zero). This provides a preliminary evidence which supports my first hypothesis that the bidders’ performance is related to their leverage change before and after the takeover, and that the more prominent the leverage increases, the more severe is the underperformance.

5.2 Leverage Difference Development between Bidder Firms and Benchmark Firms Next I examine the development of the leverage difference between the bidders and their benchmark firms from one year before throughout five years after the takeover. Panel A of Table III shows the development of the leverage difference for all sample firms. The leverage

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difference, defined as the bidder firms’ average leverage minus the benchmark firms’ average leverage, in one year before the takeover for all sample bidders is 2.75%. The difference widens to 10.37% in the first year and then gradually decreases to 3.5%, while still wider than pre-takeover level. As the leverage of the benchmark firms stays at almost the same level throughout the six years, the main drive of the development of this difference is the bidders’ leverage change due to the takeover. Unlike the evidence presented in Malmendier, Moretti and Peters (2012) where the leverage difference gradually diverges three years after the takeover, the evidence presented here is that the difference gradually converges. Combined with the evidence reported in the previous subsection that the bidder firms on average underperform, it is actually in support of Myers’ (1977) debt overhang theory. It shows that after the bidders significantly increased their leverage for the takeover, they need to continuously make effort in order to meet their debt obligations and lower their leverage level to pre-takeover level. And by doing so, they have to forgo potential positive NPV project, which further limits their growth potential.

Panel B of Table III shows the development of leverage difference grouped by their payment method. In Panel B-1 for all-cash bidders, the leverage difference again significantly widens one year after takeover from around 0% to 9.5% one year after takeover and then gradually decrease to 0% again five years after takeover. The leverage development for non-all-cash bids reported in Panel B-2 shares the similar pattern, with leverage difference increases from 4.18% to 11% then gradually decrease to 5.32%, slightly higher than pre-takeover level. This “significantly widen then gradually narrow” pattern aligns with that of all sample, therefore the bidders’ buy-and-hold abnormal returns are also negative and partially significant. The fact that the bidders in both groups take about the same time to make their leverage difference return to pre-takeover level further supports that the performance for these two groups might be indifferent, but suggest that non-all-cash bidders might actually perform slightly worse than all-cash bidder. So far from this univarate examination of leverage difference, it is still unclear for my third hypothesis that whether all-cash bidders should perform worse than bidders who pays with equity components. Panel C of Table III shows the development of leverage difference grouped by their source of financing for cash. In Panel C-1 and C-3 of Table III for bidders who financed their cash from non-debt and purely from internal funds, the pattern of the leverage difference development are quite similar: they both widen by around 3% and then gradually narrow to narrower than pre-takeover level. In Panel C-2 for bidders who financed their cash from debt, the leverage difference widens by 9% and

Does the bidder’s takeover-induced leverage change affect its post-takeover long-term performance?