Government Ownership and the Wealth Effects of Acquisition Announcements: Evidence from China

Faculty of Economics and Business Faculty of Social Sciences

Master Thesis - MSc International Financial Management

Government Ownership and the Wealth Effects of

Acquisition Announcements: Evidence from

China

Mengzhen Lei

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Abstract

Using a dataset of 438 domestic private deals and 32 cross-border private deals with Chinese acquirers from 2006 until 2010, this thesis investigates the role played by government ownership in bidders‘ stock market return from acquisition announcements. The impacts of state ownership and legal person ownership on the stock market reaction to domestic and cross-border acquisition announcements are measured respectively. In domestic cases, the results show that the relationship between the government ownership and the bidder returns exhibit a statistically significant nonlinear, inverted U-shape pattern. The findings imply that in order to generate the maximum bidder returns, the optimal state shareholding level is 20% and the optimal legal person ownership is 31%. Acquirers on average receive a positive and significant return from announcing a domestic acquisition. This study also discovers that the pure equity payment method and the relative deal size have significantly positive relationships with domestic bidder returns. In cross-border acquisitions, Chinese acquirers‘ return is positively affected by legal person ownership. Furthermore, cross-border acquisitions experienced significant losses during the global financial crisis started in 2008.

Key Words

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TABLE OF CONTENT

1.

Introduction

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2.

Literature Review

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2.1 The Announcement Effect of Acquisitions 6

2.1.1 Private Acquisition 7

2.1.2. Domestic and Cross-border Acquisitions 8

2.2 Theories Related to Firm Acquisition Activities 9

2.2.1 General Explanations for Wealth Effects of Acquiring Firms 11

2.2.2 Determinants and Variables 12

2.3 M&A activities in emerging market 16

2.3.1 Acquisitions in China and Government Ownership 17

2.4 Hypotheses Developing 24

2.4.1 Domestic Private Acquisitions in China 24

2.4.2 Cross-border Acquisitions of China 29

3.

Data and Methodology

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3.1 Data 31

3.1.1 Data Selection 31

3.1.2 Sample Descriptive Statistics 33

3.2 Measures and Methodology 36

3.2.1 Event Study 36

3.2.2 Cross-sectional Analysis 37

4.

Empirical Results

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4.1 Cumulative Abnormal Returns 41

4.1.1 Univariate results 43

4.1.2 Quintile Analysis 46

4.2 Results from the cross-sectional analysis 49

4.3 Sensitivity Test 55

5.

Conclusion

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5.1 Conclusion 57

5.2 Limitations and Directions for future research 59

References

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1. Introduction

November 23, 2010, a Chinese firm Tianjin Xinmao S&T Investment Corp offered 1 billion euro to acquire a Dutch cable manufacturing company, Draka Holding NV. This offer topped by nearly 20% an offer by the competing bidding firm, Italy‘s Prysmian SpA. Just a few months earlier, August 2, 2010, Geely Holding Group completed its acquisition of 100 per cent of Volvo unit in Ford Motor Co. in a 1.5 billion U.S dollars deal. 1.3 billion dollars were paid in cash and the rest will be paid by notes. The recent acquisition news not only has attracted widely public attention in Europe, but also made it evident that China, known primarily as a foreign direct investment destination, has ambitions for acquisitions of foreign companies.

Cross-border and domestic acquisitions by Chinese listed enterprises have become popular in recent years. By 2010, China‘s outward direct investment reached 59 billion U.S dollars, a yearly growth of 36% over 2009 (Minsistry of Commerce, PRC, 2010). Most Chinese bidders involving with cross-border acquisitions are publicly listed firms which have leading positions in their home market. Asset augmentation and market exploitation are two primary strategic motives for Chinese acquirers investing outbound. For instance, Lenovo acquired IBM PC units in 1.25 billion US dollar for global market expansion. In another case, China Investment Corporation invested 8.6 billion U.S dollars in Blackstone Group and Morgan Stanley in 2009 to pursue their managerial expertise (Chen and Lin, 2009). The deal volume and deal value of domestic acquisitions by Chinese listed firms also have been sharply increasing since 2000s. 6,300 acquisitions with a total market value of 181 billion U.S dollars were announced between 2006 and 2009 (Liang, 2009).

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undergoing continuous growth, existing literature, which focuses on the Chinese acquirers‘ performance upon announcing deals, is still limited. For this reason, it is interesting to analyze the issue of Chinese bidders‘ gains through acquisitions. Considering the dominant role of government ownership in Chinese listed firms, the impacts of ownership structures on the wealth effects of acquisition announcements are interesting to examine as well.

The primary research intention of this study is to investigate whether and how government related ownership affects Chinese bidders‘ stock return from domestic and cross-border acquisitions respectively. The shareholders‘ wealth effects of acquirers in domestic acquisitions and in cross-border acquisitions are both examined, and the potential determinants for such bidders‘ gain are also tested.

Using a sample of 438 domestic acquisition announcements and 32 cross-border acquisition announcements over a five years period, between January, 1, 2006 and December 31, 2010, this study tests six hypotheses regarding bidder returns and government ownership in each acquisition sample. The variables of cumulative abnormal return of bidders in a five-day event window and a three-day event window around the announcement day are used as dependent variables. The empirical results are generally consistent with my predictions. The results show that bidders‘ abnormal returns in domestic acquisitions are significant and positive while in cross-border acquisitions they are insignificantly negative. By pairing cross-cross-border deals and domestic deals announced by the same acquiring firms, the domestic acquisitions significantly outperform cross-border deals. In domestic acquisitions, both state ownership and legal person ownership have an inverted U-shape relationship with the bidder returns. This implies that partial government ownership increases the acquisition performance but excessive government ownership reduces bidders‘ gains. According to the regression coefficients, the optimal holding level for state shares to bring the highest bidder returns is around 20% and for legal person shares is around 31%. In cross-border acquisitions, only legal person ownership is found having significant positive influence on bidder returns, while state ownership has an insignificant negative sign. Besides, the cash payment method has a negative impact and an increase in the relative deal size has a positive impact on the bidder returns in domestic deals. The cross-border acquisitions are significantly negatively affected by the 2008 global financial crisis.

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unique characteristics. It tests whether traditional theories still hold and whether the effects of determinants remain the same. For investment practitioners, this paper provides references for predicting the stock market reaction after the announcement of an acquisition by a Chinese listed firm. For corporate decision makers, the performance of Chinese firms acquiring domestic or overseas targets in a recent period is shown in this paper. It offers background information for making acquisition decisions. For Chinese politicians and policy makers, this study provides the evidence on the relationship between current ownership structures of Chinese listed firms on corporate acquisition performance. It can be used as reference for future policies concerning adjustment of the government ownership in listed firms.

For at least three reasons, this study adds to the literature by addressing the Chinese acquirer‘s performance issue. First of all, even though the volume of acquisition deals by Chinese firms, as well as the deal value involved, has been dramatically increasing, relevant academic researches of acquisition performance are rather limited. Among the few empirical studies conducted on this topic, cross-border and domestic acquisitions by Chinese acquirers are examined separately. This paper comprises a dataset of acquisition announcements associated with both oversea targets and domestic targets and investigates the acquisition performance in both types of deals. Because the samples of cross-border acquisitions and domestic acquisitions are collected from the same period and by the same screening procedures, the results provide a clear comparison of Chinese bidders‘ performance in cross-border and domestic acquisitions. Do they receive positive or negative returns from acquisitions? Do they receive the same returns from acquiring overseas compared to acquiring inside China? All of these questions are tested and analyzed.

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Che and Qian (1998). However, when Chi et al. (2009) analyzed how state ownership affects corporate value in a domestic acquisition performance aspect, they argue that state ownership actually has a positive influence on bidder returns. By analyzing the domestic deal sample, instead of supporting one side of the either a negative or a positive effect argument, this paper reconciled previous conflicting conclusions. This study found partial government ownership benefits the bidders‘ stock returns, but excessive government ownership reduces the gain of acquirers. So there is an inverted U-shape relationship between government ownership and the bidder returns. This argument indicates that neither the negative or positive impact is absolutely constant, but there are actually different impacts on bidder returns at different levels of government ownership. This study reveals that government ownership affects differently on the acquirers‘ gain in cross-border acquisitions. Only legal person ownership is found to have positive influence on the bidders return while state ownership is not found.

Finally, the analysis performed in this study also includes numbers of other determinants that are proven having significant influences by previous research papers. But most of these studies were conducted in developed countries and use western companies as researching subjects. It is another contribution of this paper that it investigates how these conventional determinants affect in Chinese market. Can those classical determinants and theoretical explanations still apply in Chinese acquisition context? Furthermore, this study is conducted in a most recent period. It takes the influence from the recent global financial crisis on the Chinese acquires‘ performance into considerations.

In conclusion, to the best of my knowledge, this is the first comprehensive study on the bidder returns issue of both Chinese domestic and cross-border private acquisitions. Also it is the first study examining how the impacts of government ownership on the bidder return in cross-border acquisitions are different than those in domestic deals. The findings of this paper contribute to existing literatures and also provide implications to relevant practitioners, as indicated before.

The rest of content of this paper is organized as follows. In section 2, a literature review on evidences and theories related to acquisition wealth effects and Chinese government ownership is presented. Section 3 explains the dataset, the statistics of the sample and the methodology employed in this paper. Section 4 focuses on presenting the results and analysis. Conclusions and limitations of the paper are included in Section 5.

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2.1 The Announcement Effect of Acquisitions

An acquisition is a significant event for companies, which contains information about transferring assets and control of the company. According to Market Efficiency Theory, the stock price will correspondingly react upon the new released information. The primary intention of this paper is to focus on the short term shareholders wealth effects caused by acquisition announcements. Event study methodology is often used to capture such effects by measuring the cumulative abnormal shareholders returns of the involved companies for a period around the acquisition announcement date (Bruner, 2000).

Among the voluminous researches done in the past few decades the shareholder‘s gain of acquiring firms and target companies are both examined. Campa and Hernando (2004) gave an extensive survey of literatures on announcement effects. They found that there is a significant above average return (above 9%) for shareholders of the target companies after releasing an announcement of acquisition. Moreover, they reviewed thirteen studies which reported approximately 20%-30% premium of the stock prices received by target firms compared to the pre-announcement period. Furthermore, this conclusion is consisted with what Bruner (2000) and Jensen and Ruback (1983) found in their previous studies. Bruner (2000) summarized the evidence of positive and significant target shareholder wealth effect from 100 studies between the periods of 1971 till 2001. Jensen and Ruback (1983) reviewed a series of literatures before 1980 and discovered a positive gain generated from corporate takeovers for target shareholders. Not only empirical results concluded that an acquisition delivery premium gain to shareholders of target companies, managerial theories also offer an explanatory thought to the positive gain for target companies. Managerial theories, as known as non-value maximizing behavior, view the acquisition decisions are means for managers to extend their own personal interests, such as increasing manager compensations or control a larger size firm. Thus, takeover actions may result in the gain for target firm shareholders on the cost of shareholders of acquirers (Halpern, 1983). Roll (1986) argues that because of manager hubris, bidding firms incline to overestimate the value of takeover deals. Therefore, shareholders of target firms are benefit from the premium received from the bid price. In short, from both empirical and theoretical perspective, the mass researches show that target companies earn a sizable positive return after various adjustments.

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discovered that the shareholders from the buyer side receive essentially zero premiums for their shares, despite variations in time periods, deal type, and observation windows. After reviewing a group of literatures, Campa and Hernando (2004) support this finding by suggesting that acquirers‘ cumulative abnormal returns are null on average. The fact that the target company is usually much smaller than the acquiring companies may partly explain this unbalanced return gained by parties involved in takeover deals (Georgen, Renneboog, 2004). The competition among bidders may reduce the gain margin for bidders and meanwhile magnify target firms return. (Jarrell and Poulsen, 1989) The last common explanatory factor for the different wealth effects for shareholders from the bidder side and the target side has been mentioned above. Managerial hubris leads to bad acquisition decisions which are quickly reflected by negative market reaction on acquirers‘ stock prices (Roll, 1986). However, Asquith et al. (1983) found that bidding firms gain significantly during twenty-one days leading to the announcement day. Dennis and McConnel (1986) reported that there is statistically reliable evidence for positive gain of acquiring firms in their study, as well.

In this paper, I mainly aim at investigating the announcement effect of bidders for a specific type of acquisitions, namely private acquisitions. The target companies in private acquisitions are privately held by definition. Thus the research focus will be to examine the return gained by acquirers, considering we have limited access to the information of nonpublic traded firms. The finding will potentially contribute to the inconclusive discussion concerning the acquisition announcements effects for acquiring firms from previous studies.

2.1.1 Private Acquisition

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Three arguments are suggested by literatures which believe that a bid for privately held firms may lead to bidder return exceeds those obtained for public firms. First of all, Conn et al. (2005) indicated that the private acquisition process is less exposed to the public. Thus managers can easily close negotiations without losing face. Those overpaid bids derived by managers‘ hubris are less likely to occur in this case. An alternative argument is that target firm managers will compose a significant block-shareholder in the post-merge firm, which plays an important monitoring role (Chang, 1998). Lastly, as suggested by Fuller et al. (2002), the illiquid nature of closely-held private firms reduces the competition among bidders. A significant premium to acquire a private firm is less likely to be accepted by the bidder. Therefore, compared to publicly traded targets, the bidder can acquires private targets with a discount instead of paying a premium, which increases the bidders return. As the conclusion, the private acquisitions appear to impose better bidders returns (normally is positive) on announcement than those gained by bidders when the target firms are listed.

2.1.2. Domestic and Cross-border Acquisitions

On the one hand, many arguments are proposed by literatures for expecting the return from cross-border acquisitions to be higher than those from domestic acquisition deals. A careful review of these arguments is provided by Conn (2003). One important argument can be ascribed to the international diversification synergies arising from intangible and information-based assets. Brand names, technological knowledge, R&D expenditures are examples of these information-based assets (Baldwin and Caves, 1991). Moreover, achievements of economic scale and access to stronger corporate governance obtained through oversea acquisitions are considered as advantages of cross-border acquisitions (Doukas and Travlos, 1988). Froot and Stein (1988) proposed that there are natural comparative advantages for foreign acquirers compared to local bidders when the cross-border acquirer‘s country is experiencing a strong exchange rate position. Tax system differences possibly provide benefits to cross-border acquisitions as well (Scholes and Wolfson, 1990). Not only developed by theoretical studies, but also from empirical results perspective, the evidences indicating that cross-border acquisitions are more valuable in terms of the bidder returns than the domestic deals are commonly documented by Doukas and Travlos (1988), Baldwin and Caves, (1991), and Walker, (2000).

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of the impact arising from different cultural environment, institution structure, and politic policies (Dennis et al. 2002). Shaked et al. (1991) presented that it is more likely for foreign acquirers to pay an unfairly premium compared to local bidders in order to realize the strategic objective such as enter the local market, international diversification, and etc. The high premium may reduce the return of bidders from cross-border acquisitions. For instance, an empirical study done by Conn (2005) reported an overall lower bidders return from cross-border acquisitions in the announcement period than those from domestic deals, after researching a sample of 4,000 acquisitions undertaking by UK firms between 1984 and 1998. In addition, Moeller and Schlingemann (2005) reported a similar conclusion that the disadvantages of cross-border acquisitions overweigh the advantages compared to local bidders, as well.

The contrasting finding on the shareholder wealth effect of cross-border acquisitions may be related to the variety of the sample construction (numbers of private and public targets), the period studied, and the general economic performance (Von Eije and Wiegerinck, 2010). Hence, while the bidders‘ return from private acquisitions is generally suggested to be positive by the literature, there are, however, different characteristics between the domestic private acquisition announcements and cross-border private deals. A variety of variables that likely influence the bidder returns, and their specific implications with respect to cross-border private acquisitions and to domestic private acquisitions will be broadly discussed later in the literature review.

2.2 Theories Related to Firm Acquisition Activities

According to Gort (1969), mergers and acquisitions (M&A) are triggered by economic differentials among markets and subjective evaluation differences (over/under evaluation) among market participants, which may be caused by such as technologic innovation, industry restructure, and change in regulations. The underlying motivations to conduct acquisition actions are not only involved with managerial decisions, but also couple with the share price movement around the acquisition announcement date. Thus, those motivational factors which are driving M&As are necessary to study. Even though there are numerous theories indicate the motivation for M&A behaviors, in this paper we only review those theories which are tightly related to our research focus, Chinese domestic and cross-border acquisitions.

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and adoption costs accompanied with potential difficulties to coordinate a larger sized company will occur after these acquisitions. Given the zero or negative economic gain in total, all premium received by the target firms are offset by the bidders‘ loss. Another class of theories refers to value maximizing behaviors. A positive economic return is expected from acquisitions according to value maximizing behaviors. Target firms and acquiring firms share the economic gain respectively, depending on the competitiveness of market (Halpern, 1983).

Sets of motive hypotheses to acquire another firm fit these two categories. Maquieira et al. (1998) for instance reveal that mergers increase the future cash flows of the post-merged company compared to the sum of them as independent firms. This view is named the synergy theory, which populates that acquisitions create extra value to the shareholders of the newly combined company. Andrade et al. (2001) expressed that these synergies can be achieved through economic scales, enhanced capacity of productions, enlarged debt capability, and moreover, the benefits from the achievement of monopoly power. The benefits of diversification provided by an acquisition are considered in this category as well, argued by Jensen (1986).

Another particular theory called agency theory concerns that managers, as agents who conduct managerial decisions of M&A, are not always aligned with the goal of maximizing the existing shareholders‘ wealth; especially under the circumstance that there is no efficient mechanism to monitor the agency conflicts. Sudarsanam and Salami (1996) implied that the owner structure and agency conflict are a function of managerial and shareowners‘ interest alignment and entrenchment. In addition, they present that managerial ownership significantly affects both the probability of takeover occurrence and of shareholders‘ earning from a takeover. Jensen and Meckling (1976) suggested viewing the total value of a firm as the sum of valuation of shareholders and the perquisite consumed by managers as agent. Thus, the ownership structure of a company normally has impact on the relationship between principal and agents, and then influences the shareholder‘s value. For instance, Lewellen et.al. (1985) reported that managerial ownership has a positive impact on the wealth gains from takeovers for bidders.

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an acquisition bid will send a signal to the market place and the asymmetry in information will be ameliorated eventually by the market reacting on this signal.

The last hypothesis is managerial hubris. This hypothesis suggests that the shareholders from the bidders‘ side face an uncertain gain. This is due to the fact that normally only the highest offer wins in an acquiring bid process. It is very likely that the bidders pay more than the actual realizable value of the target company, which inevitably leads a loss to bidders‘ shareholders eventually. Meanwhile, it brings an abnormal return to shareholders of the target company. Roll (1986) posited this as managerial hubris. Mueller and Sirower (2003) found considerable support to this hypothesis by examining 168 merge cases. There is a significant damage to current shareholders‘ welfare caused by managers who have the hubris to over-pay the bidding price to target firms.

The above discussed motivation hypotheses explained why to conduct acquisition activities. However, some hypotheses have consistent or conflicting implications for the announcement effects on the securities‘ price of acquiring firms. To give a more explicit implication imposed by those theories, a set of general determinants of wealth effects for acquiring firms will be further discussed in more details in following sections.

2.2.1 General Explanations for Wealth Effects of Acquiring Firms

Numerous studies have examined various types of determinants that affect the impact of the announcement of an acquisition bid on stock return of the acquiring firm. In this section, three possible explanations are discussed from a rationale perspective about the phenomenon of negative or low return for the acquiring shareholders. Afterwards, I will discuss how each determinant is estimated to explain the acquiring firm returns, and its specific implication in the circumstance of domestic or cross-border acquisition bids according to previous empirical studies.

When the capital market is unbiased, the stock price impact of an acquisition announcement is constituted by two components. Firstly the economic benefits of this acquisition expected to be received by the acquirer, and secondly other information inferred by investors together with the released announcement (Moeller et al, 2004). As presented in the last section, there is plenty of evidence of the negligible or negative return for acquiring shareholders founded around the announcement date. Does this show that all of those acquisitions are poor investments for the bidders? Jarrell and Poulsen (1989) provide three rationale explanations.

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that either contains little information, or be perceived more as other information than the acquisition deal itself by investors, e.g., financing methods of a deal is sending a signal about changes in current finance structures. Under the former assumption, the disguised wealth effect to the buyer company is caused by insufficient information delivered by the announcement. Empirical support offered by Asquith et al. (1983) shows that the return of acquirers increases as the target firm size increases relative to the acquirers‘ size. As for the later assumption, Asquith et al. (1983) and Travols (1987) both indicated that investors view the decision of issuing new equity to finance an acquisition as unfavorable information. Thus the abnormal return of stock prices is significantly lower than those cases financed with cash.

The second explanation argues that the competition among bidders for one target firm depressed bidders‘ gain and magnified the target firm‘s return. Bradely et al. (1988) reported significant positive return for acquiring firms in a single bidder context and insignificant different from zero return when there are multiple bidders. Meanwhile, significant higher gain earned by shareholders from the target company is associated with the multiple-bidders situation. Jarrell and Bradely (1980) documented the gain of bidders declined from 9% to 6% among those companies who adopted the Williams Act in 1968, which is aimed to increase the competitiveness of tender offers.

The last possible explanation can be described as that the market correctly reflects the poor acquisition decision by showing unfavorable stock price reaction. As suggested in managerial hubris hypothesis and the agency theory, manager may decide to conduct an acquisition bid based on managerial self-interested motives, which is non-value maximizing behavior. Even the acquisition decision is set under the objective of maximizing value of the firm; managers may overpay the target firm as of their hubris (Roll, 1986). This explanation is supported by multiple empirical studies. For instance, Lewellen et al. (1985) stated that companies with a high level of managerial ownership are less likely to initially take takeovers resulting in a loss. And a significant positive relation is found between the percentage of equity owned by senior managers and the return from takeovers.

2.2.2 Determinants and Variables

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the determinants and the premium received by acquiring firms. There is a variety of indicators representing those determinants contained in the economic condition (global level), the market specifications (country level), and the transaction features (corporate level) (Rossi and Volpin, 2004). I will first follow majority authors to discuss the most tested firm level measures, and leave particular measures at country level to be explained later in this paper.

2.2.2.1 The Method of Payment

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It is worth to notice that usually, a positive impact of cash offer compared to equity bids may be impaired in the case of cross-border acquisition deals, especially for private overseas deals (Conn et al. 2005). The reasoning for this is that there may be other, more decisive factors for choosing the payment methods. For instance equity bids are not chosen because of the greater uncertainty and information asymmetries due to acquiring over border. Or an immediate cash payment is necessary in order to neutralize the reluctance on the target shareholders to accept a foreign equity (Guanhan, 2002). Consequently, Conn et al. (2005) did not find differences in a sample of over 4000 deals between the return of cash and non-cash deals in oversea acquisitions, nor in private acquisitions. This finding is also consistent with Chang‘s (1998) empirical analysis that no abnormal returns associating with cash offers for bidders in private acquisitions occur. Therefore, it is hard to conclude a congruent estimation for the impact of the cash payment method on the acquirers‘ return in cross-border private deals, even though the payment methods is undoubtedly a significant determinant influencing the gain of bidders.

2.2.2.2 Relative deal size

Moeller et al. (2004) tested the impact of the relative deal size on the stock price reaction to acquirers. He reported that the group of small firms as acquirers earned a 2.32% equally weighted average premium, which is significantly higher than the 0.08% abnormal return realized by the large firm group. Additionally, Asquith et al. (1983) concluded a significant, positive relationship between the relative size and the return to acquiring firm. Findings of these two studies are consistent with the above-discussed information content issue which states that when the acquirer‘s size is significant larger than the targets, the information carried by the announcement will be negligible. My study only concentrates on private acquisitions, which implies that the target firm may be much smaller in most of the cases. Therefore, the relative deal size variable is considerable relevant. In the aspect of cross-border acquisitions, Eije and Wiegerinck (2010) stated that the announcement probably adds extra value toward the international reputation of smaller acquiring firms more than big bidders.

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There is an extensive body of literature suggesting that industry diversification discounts the firm‘s value. One of the plausible explanations for this is that those firms which seek growth through industrial diversification already exhausted growth opportunities in their current industry (Lang and Stulz, 1994). Denis et al, (2002) provided a comparison to show that global diversification and industrial diversification are associated with a significant firm value discount because of inefficient investment policies. Moreover, Campa and Kedia (2002) reviewed and proved that the cost arising from inefficient capital allocation among diversified divisions, the information asymmetries between central and subsidiaries, and the agency issue associated with the decision of diversification, overweigh the benefits brought by diversification. More empirical studies revealed evidences that diversification destroys firm value as well. (Lang and Stulz, 1994; Denis et al, 2002; Campa and Kedia, 2005; Servaes, 1996) The same issue has been discussed extensively for the emerging market environment as well. Lins and Servaes (2002) discussed that in emerging countries, the substantial agent costs also surpasses the benefits generated by diversifications. The firm value discount associated with industry diversification influences all business activities, including acquisitions. The fundamental reasoning here is that when a company attempts an acquisition for entry in an unrelated industry, the industry diversification impact discounts the firm‘s value and the market will react to the announcement by adjusting the stock price to correctly reflect the pro-discounted value. Dos Santos et al. (2008) identified that there is no value loss when a foreign target within the same industry is fairly valued during acquisition. However, unrelated cross-border acquisitions result in an average significant discount of 24% caused by the industry diversification impact. Furthermore, Moeller and Schlingemann (2005) hypothesized that the stock return for US acquiring firms is negatively related to both global and industry diversification. By examining 4,430 cross-border acquisitions between 1985 and 1995, evidence is found to support their predictions.

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2.3 M&A activities in emerging market

When companies from developed countries acquire the major control of firms in emerging markets, the finding that announcement generates positive and higher abnormal return to bidders‘ shareholders has been vastly discovered among literatures. But in this paper, I will focus on discussing the wealth effect generated by acquisitions announcements where the acquiring firms are from emerging markets and the target firms are located in either the same country or different ones than the acquirers‘ home country, as referred as domestic acquisitions and cross-border acquisitions.

The characteristics of emerging markets offer both potential value creation and obstacles to acquisitions in emerging markets. Firstly, the capital market imperfection in emerging markets provides access to cheap capitals which enable firms to invest in more projects that may have to be forgone within the situation of limited capital (Chari, et al., 2004). Buckley (2004) stated that the imperfections of the capital market in emerging countries can be transformed into specific ownership advantages. For instance, an inefficient banking system provides soft loans to firms which have the attempt to acquire. Sometimes, this type of loan is required by policies to encourage firms from emerging markets to involve outward takeovers (Child and Rodrigues, 2005; Warner et al, 2004). Therefore, the benefits from accessing to cheap capital possibly increase the return of emerging economy acquirers, in both the case of domestic and cross-border acquisitions.

Second, emerging countries normally have poor protection for and lower enforcement of the interest of minority shareholders (La Porta et al., 1998). According to Dahlquist et al. (2003), a low level of regulation and protection for the right of property can be related to a lower value of the acquiring firm. Because highly regulated countries protect the bidder‘s interest by establishing a high standard of disclosure which improves investors‘ confidence. Evidences of the home country‘s governance impact are found by Bris and Cabolis (2004). They find that the better level of the shareholder protection and accounting standards in the acquirer‘s country, the larger merger premium in cross-border mergers relative to domestic acquisitions.

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between the acquisition premium paid by bidders and the degree of information asymmetry. This result holds for both domestic and cross-border acquisitions. The higher premiums paid by bidders, obviously, will cause the lower bidders ‗gain from acquisitions.

The last but not the least determinant of emerging market acquisitions is that we should take into account the emerging stock market noise. Considering the stock price in emerging countries may be noisier and less adequate as a measure of true firm value (Von Eije and Wiegerinck, 2010), the bidder returns gained from the announcement of an acquisition may be interrupted by additional noises included in the stock prices.

To conclude, the capital market imperfection provides advantages to emerging market acquirers. However, low regulation in the acquirer‘s country may reduce the emerging market bidder returns of cross-border acquisitions. And a high premium caused by high information asymmetry also suggests a lower return for bidders in emerging market. Furthermore, the extra noises on the share prices in emerging markets make the announcement wealth effect of the emerging market acquirers more difficult to be predicted.

2.3.1 Acquisitions in China and Government Ownership

2.3.1.1 Chinese government as the dominant owner of listed firms

The M&A activities have not become popular until late 1990s in China. Due to the development of the capital market, the government policy of ―converting state owned enterprises to publicly owned‖, and the improvement of the corporate law, the number of acquisition deals sharply increased after 2000.

Even though most of the state owned enterprises have been converted to listed companies, there is still a share segmentation system existing in the listed companies. This system refers to that the shares of Chinese listed companies are classified into 4 categories, namely the state shares, the legal person shares1 (also called institutional shares), the foreign investor shares and private investor shares. Among the four categories of shares, the state shares and the legal person shares are non-tradable (Wei, 2007).

State shares comprise of state-owned shares and state-owned legal person shares. State– owned shares are ultimately owned by the State Asset Management Bureau, while the

1

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owned legal person shares are controlled by corporations or institutions which are dominantly owned by the regional government or the central government and its associated ministries. Hence, state shares are under direct control by either the central government or the governmental organizations. They represent the most direct government ownership in Chinese listed companies. Meanwhile, another type of non-circulating shares is called legal person shares (also refers to institutional shares), which are shares owned by domestic legal entities, including domestic mutual funds, insurance companies, government agencies and other non-state owned corporations. This type of ownership is gained through investing capitals in listed companies or through ownership transferring agreements from other institutions. However, ―the government is the absolute owner of most domestic legal persons‖ ―only 6% of the listed companies in China did not have any state interest‖, quoted from Xue (2001). Because many of those legal entities are to some extent owned by the government, legal person shares are similar as the state shares in that their ultimate owner is the Chinese government through a pyramid owning structure (Figure 1). The most important distinction between these two types of ownership is the different interests they represent in listed firms. For the state, the primary emphasis is on the society welfare, such as employment rates, the control of the key industries, and etc. But for the legal person shareholders, the monetary profit is relatively crucial (Wei, 2007).

Figure1. Chinese listed company ownership pyramid

According to statistics, in 2005, of all outstanding shares issued by 1,381 Chinese listed companies on two Chinese stock exchanges, 65.9% of the shares fall into the non-tradable share

State Asset Management Bureau

Central & Local Government Agencies State-owned shares State-owned legal person shares Social legal person Shares Common A share, B share Common H shares Listed Company A State-owned corporate as shareholders Social legal entities Domestic individual investors

Foreign institutional & individual investors

Tradable shares Non-tradable shares

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category (Morck, Yeung, & Zhao, 2008). In addition, due to the non-circulating nature of the state shares and legal person shares, the government has more than 50% of the voting rights in 31.4% of the listed companies (Yuan, 1999). Apparently, the Chinese government holds majority control rights on corporate affairs. Consequently, the widely dispersed individual investors and a few foreign institutional investors have rather limited influence over operational decisions, financial decisions, and acquisition decisions of firms, because the Chinese government has a dominant position as shareholders (Xue, 2001). Therefore, when we study acquisition wealth effects in China, the government dominating ownership is an evident determinant that has to be taken into account.

2.3.1.2 Government Ownership and the detrimental effects

As suggested by the agency theory, the ownership structure is a critical mechanism to guarantee effective corporate governance (Keasey, 1997). The importance of corporate governance is particularly increased in emerging economies because they are facing capital market imperfections, weak accountabilities, and information asymmetries (Young et al., 2008). Using a sample of Chinese publicly listed companies, Su et al. (2008) found a U-shape relationship between the concentration of the majority ownership and the indicators of good corporate governance. Buckley et al. (2007) also stated that the current legal system of China does not provide strong support for an impersonal, but rule-based governance structure. Without strong corporate governance, the controlling shareholders may pursue their own interests on the cost of the minority shareholders, which is known as the principal-principal conflict.

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illustrated that in the situation of a concentrated ownership, the agency problem is fierce between the large shareholders and small, diversified shareholders. The minority shareholders are exposed to the risk of losing the right due to the controlling shareholders, who easily gain effective control over the firm‘s issues. This type of agency problem is so called the principal-principal conflict (Dharwadkar et.al, 2000).

In the Chinese corporate acquisitions aspect, Su et al. (2008) proposed that the dominant ownership of the Chinese government in listed companies fosters a divergence of interest between the dominant shareholders (government) and the minority shareholders (foreign financial institution and individual shareholders). This is namely the principal-principal conflict which is a prevalent issue among emerging economies, such as China. For instance, as China is officially still a communistic country, some of acquisition bids by firms which are dominantly owned by the government may be involved with certain political objectives over pure economic interests, such as attempt to preserve society stable, access to natural resource (Chen and Young, 2009). Since the political purpose of the Chinese government as the controlling shareholder may be actually contradictory to the value maximization purpose of individual shareholders, the principal–principal problems will arise (Su et al., 2008).

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In short, the detrimental effect predicts that the concentrated government ownership results in a possible principal-principal conflict and the potential managerial hubris issue during an acquisition process. They both indicate disadvantages for the minority shareholders interests.

2.3.1.3 Government Ownership and the beneficial effect

The concentrated ownership guarantees sufficient control over a firm‘s decisions. Hence, when the controlling owners‘ interests are aligned with the best interests of investors, it might bring benefits to the normal investors. Particularly, La porta et al. (1999b) discussed that in countries with a less developed legal and institutional environment, the beneficial effect of the concentrated ownership is significantly positive. Gomes (2000) explained that this positive effect is because of the reputation and the power government usually enjoy

In China‘s case, there are also researchers who indicate that the dominant government ownership can be transferred to an ownership advantage because of its emerging and imperfect capital market. Gunasekarage et al, (2007) argued that a strong connection with the state brings a company more leverage to cope with governmental bureaucracy and can offers it special favors. Scott (2002) indicated that state owned (or state associated) companies may have access to capital that is provided below the market rate or with soft budget constraints. This enables them to undertake projects that are normally not profitable. The beneficial effect is especially obvious for some of the Chinese state-owned listed companies. These state-owned companies select the most profitable business units and transfer them into a subsidiary company which is then publically offered. After this sub-firm successfully becomes public the parent company can use it in order to access the stock market for finances. Under this circumstance, the interests between the controlling owners and minority investors are rather aligned; both pursue profit maximization in order to better serve other units of the parent company (Liu and Lu, 2002).

2.3.1.4 Combining the detrimental effect and the beneficial effect

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holds while controlling for other variables such as firm size, leverage, foreign ownership, and locations.

Sun and Tong (2003) hypothesized different impacts of state shares and legal person shares on firms‘ market value. Their results support the view that state ownership has a negative impact on post-listed firm performance while legal person ownership has a positive impact. These differences may not be a coincidence. Supporting evidence is provided by Qi et al, (2000) who applied the return on equity (ROE) as the indicator for a firms‘ performance. Their sample consists of all listed companies on the Shanghai Stock Exchange from 1991 to 1996. They discovered a significant and negative influence of state ownership and a significant and positive influence of legal person ownership on the performance of Chinese listed companies. Furthermore, they found that the stronger the dominance of legal person ownership over the state ownership, the higher the ROE the companies earned.

The completely different impacts of state and legal person shares on the corporate performance can be illustrated by various arguments. The first argument is developed by Che and Qian (1998) who stated that enterprises tend to hide revenues in an environment that lacks secured property rights given by the law in order to fight against government encroachment. The fear that the government will occupy the economic profits limits the incentive of managers from firms with a large percentage of state shareholding. Legal person ownership prevents the possibility of state predation, which in turn, reduces costly revenue hiding action. Secondly, state shares are ultimately owned by the State Asset Management Bureau which also is in charge of numerous other companies. This significantly impairs the ability of the state government to monitor all companies‘ behaviors and performance. On the contrary, a legal person entity typically is a large block-holder in only one or a few companies which allows them to monitor more actively (Xu and Wang, 1997). Lastly, unlike the state ownership, many legal entities which hold the legal person shares used to be parent companies of those public firms before the shares converted. Thus, many legal entities still maintain close business connections with these firms. The tight business connection provides incentives for legal person shareholders to ensure good performance of these firms; otherwise they also suffer from the poor profitability (Sun and Tong, 2003).

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ownership is sufficiently large. The inflection point for the state ownership varied between 31% and 36.7%, while for the legal person ownership is the point lies between 13.4% and 35.5%.

A study undertaken by Sun et al, (1999) showed support for an inverted U-shape relationship. They argue that when a government related enterprise owns a small stake in a listed firm the firm‘s performance improves. However, if this type of ownership is beyond a certain level the excessive equity holding correlates with poorer firm performance. The results hold no matter using either state ownership, legal person ownership, or a combination of both as proxies for government ownership. Ding et al, (2007) confirmed the positive impact of partial government ownership. A significant, non-linear, inverted U-shape pattern between the earning of a firm and the ownership concentration was proposed. They also revealed that the optimal shareholding level lies between 55% and 60%. Wei et al. (2005) derived a consistent result by studying 5,284 Chinese listed firms within a ten years period from 1991 to 2001. In the first part of their research, a significantly negative influence of the level of state and legal person shares on the Tobin‘s Q ratio for firms is reported. After analyzing the data deeper they reported a significant convex relation existing between Tobin‘s Q and both state and legal person shares, irrespective of whether these two ownership variables were tested together or as separate variables tested independently.

A common aspect among most studies proposing a convex influence of government ownership is that they found significant results from ordinary linear regression models at the first step. However, they continued analyzing if the impacts remained the same at different level of ownership. After adding the square terms of ownership into the regression model the results showed that a convex relation possesses more explanatory power than a linear relation. From this perspective the two streams of empirical studies are convergent to some extent. In fact, an extensive amount of studies found such an inverted U-shape relationship between insider ownership, or institutional ownership and firm performance for U.S firms (Morck et.al, 2988; McConnell and Servaes, 1990).

One important divergence between these two streams of studies is that linear relationship studies normally found contrasting impacts of state and legal person ownership on corporate performances while nonlinear relationship studies propose that both types of ownerships have similar convex impact curves.

24 the firm‘s decisions.

So far the empirical researches gave mixed opinions regarding the impact of concentrated government ownership on firm performance. The conflicting evidences from previous studies highlight the complexity of this issue. One stream of empirical studies suggests a linear relationship between government ownership and publicly traded firms‘ value, and a widely discussed view suggests that state ownership and legal person ownership may have contrasting impacts on a firm‘s performance. Additionally, there is another stream of studies indicating that the relationship takes form of a non-linear convex shape. This stream of opinions assumes that the beneficial effect of government ownership on the firm‘s performance is initially stronger than the detrimental effect. However, the detrimental effect gradually grows until it eventually dominates the beneficial effect, along with the ownership level rising up.

2.4 Hypotheses Developing

So far this literature review has discussed theories on the acquisition announcement wealth effects and the general impacts of the government ownership structure in the Chinese context. I will now discuss whether, and if so, how the ownership structure affects the Chinese bidders‘ gain.

As introduced before, the dominant shareholding position of the Chinese government affects listed firms‘ stock market value and performance. An acquiring company‘s stock return, measured by the stock price changes around the announcement date, is based on the company‘s value on the stock market. Hence the acquisition announcement wealth effect of the acquiring firm is part of this firm‘s performance on the stock market. It is reasonable to predict the government ownership structure has an impact on bidders‘ stock returns when the announcements are released.

To explore this issue, the following topics are examined: (a) the cumulative abnormal return (CAR) received by Chinese acquirers from domestic and cross-border private acquisitions, (b) whether the CAR is driven by state or legal person ownership, (c) whether the impacts change according to the degree of state or legal person ownership and, finally, (d) any differences on the effects of the return from domestic acquisitions compared to those of cross-border acquisitions.

2.4.1 Domestic Private Acquisitions in China

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related acquisitions are from listed companies bidding on private companies. Between the years 2006 and 2009, more than 6,300 acquisitions undertaken by Chinese firms as acquirers have been announced, involving a total market value of USD 181 billion. Over 70% of the deal volumes from these acquisitions were within the domestic market (mainland market2) (Liang, 2009).

However, there are only a handful of studies on the stock market reaction to the announcements of domestic acquisitions by Chinese acquirers. Most of studies that do exist on this topic were conducted in recent years. One important study is done by Chi et al.(2009). By studying a sample of 1,148 domestic acquisitions from 1998 to 2003, they document a significant positive bidder return upon the acquisition announcement. The average CAR in four short event windows (-2/2, -1/1, 0/1, -1/0) all proved to be significantly positive at either 10% or 1%. Furthermore, they state that cash payment is the dominant payment method. Another interesting study which contributes to this topic is undertaken by Liang (2009). He compared the impact of announcements by U.S and Chinese listed companies on the acquiring firms‘ stock return. Significant announcement effects were only found in the Chinese firms sample during a ten days event window prior to the announcement date, while U.S investors realized no profit by trading before the official acquisition information released. He argues that the information perception of an acquisition announcement by Chinese investors is more favorable than by U.S. investors.

As discussed in Section 2.1.2, private acquisitions are often found to generate a positive bidder returns in both cases of domestic and overseas deals. As a private acquisition process is normally less exposed to public, managers of acquiring firms can more easily close negotiations without losing reputation. This advantage reduces the risk of managerial hubris to some extent (Conn et al, 2005). Another advantage is that private target managers can compose an active block-shareholder in the post-merged firm which improves the corporate governance (Chang, 1998). Furthermore, the illiquid nature of privately held firms reduces the competition among bidders, which results in a lower price needed for acquiring the target (Fuller et al, 2002). In this research, all target companies are privately held. Based on the above theoretical reasons, it is likely that the bidder returns will reflect a positive market reaction In addition, the empirical study done by Chi et al. (2009) confirmed the significant positive CARs for Chinese acquiring firms in the short term around the announcement date. Therefore, I have reason to believe that Chinese investors react positively toward domestic acquisitions announcements when the targets

2

26 are private firms. My first hypothesis is therefore:

H1. The Announcement of a domestic acquisition leads to positive stock market reactions for Chinese acquiring firms.

Two streams of studies regarding the impact of the government ownership on Chinese firms‘ performance have been discussed in details in section 2.3.1.3. However, very limited research carefully examined the relationship between the government ownership and Chinese acquirers‘ stock return in the acquisition announcement context.

Among those empirical studies of the stream reporting linear relationships, Sun and Tong (2003), Qi et al. (2000), and Che and Qian (1998) consistently reported that state ownership has a negative impact on Chinese listed firms‘ market performance, while legal person ownership has a positive impact. But Chi, Sun and Young (2009) believed that the influence from the ownership works very differently in the context of acquisition announcement effects. Their empirical research results also support this argument. According to Chi et al. (2009), state ownership has a significant positive influence on the acquirers‘ return, while the legal person ownership has a significantly negative impact. Both coefficients are statistically significant at the 1% level. The explanation for such a contrasting finding in the acquisition wealth effect context can be understood as follows. First, acquisitions are generally considered to be an effective way of realizing strategic expansion. This sends a signal to the market that the firm is in a growing phrase (Liang, 2009). The thriving of listed companies is crucial to the success of the Chinese economic reformation, which is the primary objective of the government. Hence, in the case of acquisition, listed companies with more state ownership (have better connection with government) can arrange a more profitable deal for themselves than others. Actually, Chinese investors typically understand that a tight connection with the government can be a valuable resource to acquire target firms for a good price. The beneficial effect of government ownership in the acquisition context is especially strong and straightforward than in other corporate affairs.

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value often found by prior studies. The non-linear shape is due to the tradeoff between the beneficial and detrimental effects caused by the government ownership. Some other types of ownership are also uncovered that they have non-linear impacts on the corporate performance in terms of acquisition decisions. For instance, Subrahmanyam et al. (1997) found that the return for acquirers in bank acquisitions is positively associated with a low level of insider ownership and negatively related with a high level of insider ownership. Loderer and Martin (1997) found a nonlinear relationship between the executive ownership and the bidder‘s return for U.S companies as well. Cosh and Hughes (2001) report evidence of a non-linear relationship between the board ownership and the post-takeover share returns.

Theoretically, besides the beneficial effects of the state ownership, we also could not neglect potential detrimental effects for acquirers to gain from acquisitions. The principal-principal conflict suggests that a firm, who is highly owned by the state, may decide to acquire not based on profitability but on political objectives. An acquiring firm has a higher level of state ownership, the more likely that it will be facing the principal-principal conflict. At the same time it indicates that less influence can be owned by other shareholders. It is the same story for the concern of potential manager hubris because the firm will lack effective governances. The higher level of state ownership means that the Chinese Assets Management Bureau increases its role as shareholder. However, the Chinese Assets Management Bureau is in charge of numerous other companies at the same time (Xu and Wang, 1997). This situation substantially impairs its ability to monitor the managerial hubris issue during an acquisition process. Therefore, these companies will possibly be suffering more from paying a too high premium for a deal. Both of these two factors predict that when the state ownership rises up to a high enough level, the detrimental effect can be so strong that it overcomes the beneficial effect. This prediction is consistent with the argument that partial government ownership has a positive effect on the corporate performance, but also with the argument that the disadvantages will surpass the advantages at a certain level of governmental shareholding (Ma and Wei, 2004; Ding et.al, 2007, Su et.al, 1999).

Considering that the focus of this paper is not only on whether there is an impact caused by the state ownership on the CAR, but also on testing the specific influence at the different levels of state ownership. Therefore, partly motivated by the empirical finding by a recent study of Chi et al. (2009), I assume that at a low level of state ownership there is a beneficial effect on the bidder returns, which becomes a detrimental effect when the state ownership rises beyond a certain level. Therefore I formulate the second hypothesis as:

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As elaborated in previous sections, legal person shareholding is considered a type of government ownership. The differences of legal person and state ownership include: (1) legal person ownership is less directly controlled by the Chinese government (more distance from the top layer of the pyramid controlling structure); (2) legal person ownership has a stronger monetary profit focus. A majority of the studies from the linear relationship stream reports a positive impact of the legal person ownership on the corporate performance (Sun and Tong, 2003; Qi et al. 2000), whereas the non-linear relationship studies report similar impacts of the state and legal person ownership on corporate value. Both state and legal person ownership are uncovered as having an inverted-U shape relation with the corporate performance, although their curves have different inflection points (Ma and Wei, 2004; Sun et al, 1999; Wei et al. 2005).

By studying 1,148 domestic acquisition deals of Chinese listed firms, Chi et al. (2009) found a significant negative influence of legal person ownership on the acquirer‘s return. The main explanation for this negative impact is that the advantages enjoyed by the acquirers are impaired due to being less closely associated with the central government. Nevertheless, companies with a less strong central government connection (higher level of legal person ownership) suffer less from the government ownership related detrimental effects. For instance, the nature of the legal person ownership is more profit maximization oriented. It indicates possible less goal divergences between the legal person shareholders and the common shareholders, which implies less principal-principal conflicts. Also, the profit pursuing nature of the legal person ownership provides incentives for actively monitoring and preventing the managerial hubris issue during an acquisition. In short, both beneficial and detrimental effects can be smaller for legal person ownership.

All studies suggesting a convex relationship between the government ownership and firm performance do not find a distinct impact between the state and legal person shares. Considering this, I assume that the legal person ownership has a non-linear inverted U-shape relationship for the acquirers‘ return as well. Acquirers with an increased level of legal person shareholding perform better at first because of the beneficial effects, but will turn to a negative performance when there is an excessive level of legal person shareholding due to the increased detrimental effects. As a result, I formulate the third hypothesis:

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2.4.2 Cross-border Acquisitions of China

Over the past decades the economic reformation in China has fueled the outward foreign direct investment (FDI), making it grow in a rapid speed. China starts to emerge as an important source of outward foreign direct investment in recent years, especially towards the developing economies. The total sum of China‘s FDI was 30 billion USD between the years 1978 and 2002, while increasing in 2010 to a FDI value of 59 billion USD, which is a growth of 36% compared to 2009. In 3,125 foreign enterprises located over 129 countries investments were made by Chinese firms (MOC, 2010). The FDI vehicles of Chinese firms are also experiencing a swift from the joint-ventures and setting up subsidiaries to cross-border mergers and acquisitions. Cross-border acquisitions undergone by Chinese listed firms have become a dominant means to realize the international expansions, especially after the financial crisis. Compared to 2003, the deal value of outbound mergers and acquisitions by Chinese firms in 2008 increased from far below 5,000 million USD to above 20,000 USD million (Chen and Lin, 2009).

The motives of this substantial expansion trend are divided into two types. The first motive is asset augmentation. Firms aim to gain resources and knowledge in order to increase their capabilities and productivity (Dunning, 2006). Deals supported by the government in order to ensure the supply of scarce natural resources, such as minerals, petroleum, fishery, and etc., fall into this category as well (Zhan, 1995). Another important motive that drives Chinese firms to undertake overseas acquisitions is asset exploitation/market seeking. Firms make acquisitions because they are seeking access to new markets and try to leverage the acquirer‘s specific ownership advantages which allows them to obtain a competitive advantage over local firms in the host country (Dunning, 2006). Dunning (2006) also suggested that these two motives are not mutually exclusive. Instead, companies may pursue both motives at the same time.

As discussed previously, most studies conclude that bidders earn a positive abnormal gain from private acquisitions. The conclusion holds for cross-border private acquisitions as well. According to an empirical research done by Chen and Lin (2009), using a sample comprising all cross-border acquisition deals undertaken by Chinese listed firms between 2002 and 2008, a significant positive average CAR is earned by Chinese acquirers for all three short run event windows (-2/+2, -1/+1, 0/+1). This result shows that Chinese investors perceive the cross-border acquisitions announcement positively. As both theories have predicted and empirical evidences have shown that Chinese acquirers receive a positive market reaction upon the published announcement, I hypothesized that: