MERGERS

Mergers



Mergers

Introduction

Traditional event studies estimate wealth effects associated with corporate actions, such as mergers, by implicitly assuming that excess demand curves for stocks are perfectly elastic. As a result, measured abnormal returns are generally attributed to the underlying event. For example, it has been well documented that acquiring companies that use their stock as the merger consideration experience announcement period abnormal returns between -2 percent and -3 percent. Conversely, cash acquirers experience flat to slightly positive abnormal returns. The negative stock price reaction to stock-financed mergers is often taken as support for information-based theories of financial policy and investment policy.

Common interpretations of the negative stock price reactions are that acquirers use stock as the form of payment when their stock is overvalued or that the market perceives the merger to be a value-destroying investment project. Evidence presented in this paper suggests that a substantial part of the negative reaction to stock merger announcements is due to downward price pressure caused by merger arbitrage short selling of acquirers' stocks around merger announcement dates. In particular, if excess demand curves for stocks are downward sloping in the short-run, then increases in the supply of stock will cause the equilibrium price to decrease. Although the common assumption that stocks' supply curves are vertical and fixed may be reasonable in many situations, it is unlikely to hold around merger announcements, when short sellers dramatically increase the effective supply of shares.

Researchers studying the market for securities have long been interested in the notion of price pressure and downward-sloping excess demand curves for stocks. In a perfect capital market, excess demand curves for stocks are perfectly elastic—investors can buy or sell unlimited amounts of stock at a market price that reflects all relevant information. As a result, shifts in excess demand caused by uninformed trading will have no impact on price. In real world capital markets, market frictions will limit market forces from keeping excess demand curves perfectly elastic. Scholes (1972) proposes two alternatives to the perfect capital market hypothesis.

One is the price pressure hypothesis, which asserts that prices will temporarily diverge from their information-efficient values with uninformed shifts in excess demand to compensate those that provide liquidity. Mechanically, this occurs when prices return to their information-efficient values, presumably over a short horizon. The second alternative is the long-run downward sloping demand curve hypothesis. If individual securities do not have perfect substitutes then arbitrage will be ineffective in keeping excess demand curves horizontal. Scholes is also one of the first to empirically test for price pressure effects by examining large block trades. However, it is difficult to hold the information effects associated with these trades constant, and therefore to distinguish between competing hypotheses. If new information is revealed, all hypotheses predict a price change.

The most convincing evidence of price pressure for stocks comes from studies suggesting that uninformed demand affects prices. Harris and Gurel (1986) and Shleifer (1986) estimate abnormal returns for firms added to the S&P 500 index to be 3 ...