Mergers in ‘hot’ markets

19/02/2019

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Earnings management ahead of merger bids is more pronounced in ‘hot’ markets and can lead to significant changes in share prices that are not reversed when a stock-for-stock bid is later announced, finds a new study co-authored by Professor Geoff Meeks of Cambridge Judge Business School.

Accounting studies have long recognised that acquirers in stock-for-stock mergers and acquisitions (M&A) often manage earnings upwards ahead of a bid. Other research has shown that when stock prices are rising, M&A activity increases and more deals are financed with stock.

But how does this M&A experience differ in “hot” and “cold” markets?

A study co-authored by Geoff Meeks, Emeritus Professor of Financial Accounting at Cambridge Judge Business School, concludes that such earnings management is more pronounced in hot markets, share price effects can be “significant” in these heated conditions, and share-for-share bids which might not have succeeded in the absence of the earnings management could be accepted.

“The extent to which such an earnings management strategy is successful depends on the prevailing market conditions,” says the study published in the Journal of Accounting and Public Policy. “In high M&A activity phases, the evidence suggests that discretionary accruals indeed enable share acquirers to earn positive abnormal returns and to inflate their share price in the period preceding the bid announcement. By contrast, in low M&A activity phases, earnings management by share acquirers does not seem to have the intended impact on the share price.”

Discretionary accruals might increase reported earnings for the current year by, for example, understating doubtful debts owed to the firm, understating the impairment of inventories, or including an inflated share of earnings from multi-period contracts.

Does the market later punish such earnings management? Hardly. “Our results indicate that the market typically attaches a premium to firms that beat analysts’ earnings expectations even if these have been achieved through earnings management,” the paper concludes.

The paper – entitled “Acquirers’ earnings management ahead of stock-for-stock bids in ‘hot’ and ‘cold’ markets” – is co-authored by Antonia Botsari of the European Investment Fund in Luxembourg and Associate of Cambridge Judge Business School, and by Professor Geoff Meeks of Cambridge Judge Business School.

Geoff Meeks comments on some of the study’s methods, findings and conclusions:

Earnings management is nothing new, but we wanted to focus on how it differs in various market situations. We looked at M&A in the UK, the largest market in Europe, and compared periods when there was vigorous merger activity and stock prices were rising (1997-2000 and 2003-07) with slack periods (2000-02 and 2007-10). We focused on non-utility and non-financial companies (banks, for example, have idiosyncratic accounting arrangements), and included only pure share-exchange deals – so we ended up with a final sample of 113 deals. Although the study focuses on the UK, we believe that the results are likely also to apply to Europe more broadly, and to the US, where stock markets and merger processes are similar.

For the average share acquirer during our study period, earnings management temporarily increased the return on assets by a third, and led to a significant increase in market value. Assuming other factors remain unchanged, this would be associated with a corresponding reduction in the number of shares required by target shareholders, as each share would be worth more. This translates into higher earnings per share for the acquirer after merger, a key benchmark for investors.

In hot markets, the premium attached to firms that beat analysts’ expectations through earnings management is not reversed when stock-for-stock bids are later announced. This runs counter to the way signalling theory might predict.

The ability of investors to “see through” and “reverse out” of earnings management is affected by market conditions. As the economist John Kenneth Galbraith argued in his classic study of stock markets, The Great Crash of 1929: “In good times, people are relaxed, trusting…. In depressions all this is reversed. Money is watched with a narrow, suspicious eye.… Audits are penetrating and meticulous.”

Earnings management distorts the M&A process. By flattering the acquiring company’s earnings record prior to the share bid, a more favourable share-swap ratio is achieved, and without such flattery acquirer executives may not have won target shareholders’ support for the deal as this would appear less attractive.

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