Julie Lei Zhu

Holdups, Renegotiation, and Deal Protection in Mergers

We examine the contracting and negotiation process in mergers using an incomplete contracts framework. Our multi-period model allows for the arrival of new information and renegotiation after the signing of an initial merger agreement but before deal completion or termination. A properly designed initial contract solves the holdup problem during renegotiation and induces higher deal-specific effort, including the due diligence assessment of the deal. The contract grants an option to the target to terminate the merger, where the strike on the option compensates the acquirer’s deal-specific effort without imposing excessive costs on the target for pursuing non-merger alternatives. The option strike can be implemented by the use of deal protection devices, such as a target termination fee and/or an acquirer lockup. Employing a large sample of stock mergers, we find evidence supporting model predictions for the renegotiation of contracts, deal outcomes and the use of deal protection devices.

Earnings-reducing Activities before Management Buyouts

During the year prior to management buyout (MBOs) announcements, some target firms exhibit abnormally high discretionary expenses in selling, general and administration, abnormally low discretionary accruals, and realize losses from asset sales. Higher discretionary expenses and losses from asset sales are associated with lower pre-MBO abnormal stock returns, especially for firms with higher insider ownership, less institutional monitoring and higher information asymmetry. They are also associated with better post-MBO operating performance. None of these activities affects the likelihood of MBO deal completion, announcement period abnormal returns, or offer premium. These target firms do not show such abnormal activities in other years before the MBOs or after the MBOs. Our results suggest that outside investors and the market do not fully understand the earnings-reducing activities before MBOs, and such ‘operational engineering’ allows managers to acquire the targets “on the cheap” and to show better post-MBO performance. JEL Classifications: G34, G14, M41.

Enforceability and the Effectiveness of Laws and Regulations

Controlling shareholders in China can divert assets from listed firms or coerce firms to serve as guarantors on questionable loans. A new rule was enacted prohibiting diversion for ‘non-operational’ purposes, and firms complying with this rule experienced a reduction in related party transactions, an increase in investment and dividends, and better performance. Another contemporary rule aimed to standardize practice of firms providing loan guarantees, but had no impact on firms. Our results highlight the importance of enforceability: laws and regulations that can be enforced at lower costs are more likely to succeed, especially in countries with weak formal institutions.

Accounting-Based Estimates of the Cost of Capital: A Third Way

This paper offers an approach for estimating the cost of capital from observed accounting information and compares the resulting estimates to so-called implied cost of capital (ICC) calculations and those from asset pricing models. The approach is based on two ideas. First, buying expected earnings growth is risky; thus, any variable that predicts expected earnings growth that is at risk of not being realized is potentially an indicator of the cost of capital. Second, accounting principles induce earnings growth that ties to risk; thus, an accounting number generated under these principles potentially indicates of the cost of capital. The paper combines such numbers into a cost-of-capital estimate. The estimates perform well in validation tests, in contrast to the alternatives that are the current standards.

Return to Invested Capital and the Performance of Mergers and Acquisitions

We evaluate the efficiency of capital deployment for acquiring firms before M&As, and link this ex ante measure to firms’ post-acquisition performance. We construct the efficiency measure as the residual from regressions of firms’ return on assets, net of cost of capital, on invested capital and other firm characteristics for each industry and year. A higher residual thus indicates that a firm generates higher net returns on investment than its industry peers in a given year. Acquirers with higher residuals have higher announcement returns and better long-run operating and stock performance than acquirers with lower residuals. The hedge portfolios based on the measure also generate significant abnormal returns.

A New Measure for Shareholder Value Creation and the Performance of Mergers and Acquisitions

This paper develops a new measure for shareholder value creation to assess the efficiency of acquiring firms in utilizing capital before mergers and acquisitions (M&As) and links this measure to acquirers’ post-acquisition performance. Based on the concept of residual earnings, I define the measure as the residual from regressions of firms’ excess earnings— earnings in excess of cost of capital—on invested capital and other firm characteristics for each industry and year. A positive (negative) residual indicates a firm is able to generate excess return on invested capital at a higher (lower) rate than its industry peers in a given year. The announcement returns for acquirers with low residuals are lower than those for acquirers with high residuals. Moreover, this measure, constructed before the M&A transaction, (a) predicts both the operating and long-run abnormal stock performance of merged firms after the acquisitions and (b) hedge portfolios based on the measure generate substantial abnormal returns. Overall, the results indicate that investors do not fully recognize how efficient acquirers have been in utilizing capital before M&As and that incorporating the new value creation measure into the decision process of large-scale M&As can help protect shareholder wealth.