Why is cash the preferred M&A currency in Europe?

Mara Faccio

Mendoza College of Business

University of Notre Dame

Notre Dame, IN 46556

and

Ronald W. Masulis

Owen Graduate School of Management

Vanderbilt University

401 21st Avenue South

Nashville, TN 37203

Version: November 14, 2002

Why is cash the preferred M&A currency in Europe?

Abstract

Mergers and acquisitions (M&A) can be some of the largest investment decisions a firm ever makes. We study the financing of M&A transactions by European bidders over the 1997-2000 period. A major advantage of this dataset is that it allows for a wide range of institutional differences and deal types. Models of the percentage of cash financing and the likelihood of 100% cash financing are developed and estimated. We find that not only bidder characteristics, but also deal characteristics and target characteristics affect the M&A financing method chosen. More specifically, we find that bidder objectives and characteristics significantly affect M&A financing decisions, including preservation of corporate control, tax minimization, debt capacity constraints, bidder equity capitalization, as well as its asset growth and prior stock price runup. The financing decision is also influenced by several deal and target characteristics such as deal size, cross-industry and cross border deals and publicly listed and bankrupt targets. Several capital market regulations are also influential. The effects of M&A legal structure choices on financing decisions are also explored.

I. Introduction

Global M&A activity has grown dramatically over the last ten years, bringing with it major changes in the organization and control of economic activity around the world. Yet, there is much about the M&A process and the major decisions that firms make which we do not fully understand. One key M&A decision is the choice of financing method. In this study we examine the typical methods of payment and determinants of that choice. This financing decision is important for a number of reasons. It determines the portion of the synergies captured by the bidder and the fraction of any overpayment borne by acquiring shareholders. It can significantly impact acquirer capital structure, future profitability, subsequent financing choices and ownership structure.

While the vast majority of research centers on US M&A activity, this has the disadvantage of holding many institutional factors relatively fixed. To better evaluate the importance of a wider range of national regulatory and economic effects, we study merger activity across a broad sample of European bidders. While stock financing of M&A activity in the US has dramatically increased in the 1990s, in contrast Europe exhibits a much lower frequency of stock financing. To better understand the causes for these different financing choices, we examine the economic factors influencing M&A financing decisions in the European marketplace.

The choice of merger currency can have important implications for an acquirer because the issuance of new stock can weaken the voting power of the current dominant shareholders. If preserving control is an important consideration for the current management and board, then an acquirer is going to have strong incentives to choose cash over stock financing. This incentive is likely to be strongest when the largest shareholder has an intermediate level of voting control in the 33% to 67% range. It is likely to be weak when there is diffuse share ownership since there is no existing controlling block that is being threatened. It is also likely to be weak when the largest shareholder has a very high level of control, so that the stock issued in the merger does not threaten his or her control of the firm. This hypothesis consistent with the theories of Harris and Raviv (1988) and Stulz (1988) that managers with significant ownership positions will be reluctant to dilute ownership position and risk loss of control by issuing stock.

Cash based M&A transactions generally involve debt financing. Thus, there is an important capital structure effect induced by this decision, especially when a deal represents a relatively large fraction of the combined firm. The M&A financing decision can affect a buyer’s future profitability, its ability to make further acquisitions and its future choice of M&A currency.

There are several of key questions we explore. To what extent is the M&A currency decision determined by buyer financing constraints and corporate control objectives? A buyer’s size and recent stock price runup are potentially important determinants of its financing choice. Tangible assets as a fraction of total assets is also likely to be an important, since it can impact a bidder’s borrowing capacity. If the bid is unfriendly, then deal execution speed can also be an important consideration. These variables may well constrain an acquirer in important ways. Turning to sellers, we expect them to prefer cash to stock if bidder stock is not widely held, since liquidity and risk reduction are major motives for selling private firms. A seller may also be wary of taking a minority equity position in a buyer due to moral hazard considerations. Allocation of deal risk and expected M&A benefits among buyer and seller stockholders is also determined by M&A currency choice. Bidder expectations concerning the risks and expected rewards of the M&A deal can also affect their willingness to accept bidder stock as consideration in the deal. Greater bidder asset growth and a higher stock gains are likely to make the bidder’s stock look more attractive, while greater stock price volatility can make the stock unattractive. In addition to these considerations, the relative negotiating position of the two parties is important. Presumably, targets that are more profitable with relatively large market shares, are privately held, or are corporate subsidiaries have relatively greater negotiating power.

In section II we review the existing research in the area and discuss our variables. Our analysis of European M&A activity begins in section III where we document data sources and present statistics on the trends over time in M&A financing decisions. We also present bidder characteristics by type of M&A financing decision. Section IV presents our primary empirical results concerning the determinants of M&A financing choices and explores the robustness of these results. The last section summarizes our empirical findings and conclusions.

II. Prior Literature and Hypotheses Explaining Financing Decisions

In the analysis to follow, we classify the form of payment into cash and stock. Following Martin (1986) and Ghosh and Ruland (1998), “cash” includes only deals relaying on cash, liabilities and newly issued notes. Stock includes stock with full voting right or inferior or no voting rights. Our focus is on the bidder’s choice of M&A financing, recognizing that targets will also have considerable influence over the final terms of an M&A deal. However, if the financing choice of the target is unacceptable to the bidder, then the M&A transaction will be still born. For the deal to succeed, the bidder must be happy with the financing structure of the deal. Moreover there are strong reasons for the bidder to prefer one financing structure over another such as threats to by a majority shareholder of the bidder, the ability to minimize taxes, the financial feasibility of the transaction given the bidder’s unused debt capacity and available liquid assets and the bidder’s future investment and M&A plans. Since we include in our analysis both successful and unsuccessful bids, we are further motivated to focus on the bidders’ financing objectives.

We take two approaches to analyzing the method of payment decision. First, we measure the proportion of cash and the proportion of stocks in each deal. The variables PERCENT CASH and PERCENT STOCK measure these proportions. Second, we classify deals into those containing only cash (CASH ONLY), only stocks (STOCK ONLY), or a mix of cash and stocks (CASH W STOCK). We next turn to the potential determinants of the financing decision where we segment the analysis into buyer and seller motivations. Several other proxies and control variables are discussed later on in a robustness tests section.

[Since most merger financing choices represent a decision to issue debt or equity, there are potential moral hazard and adverse selection effects involved. Travlos (1987) explores the empirical validity of the adverse selection problem in equity offerings developed by Myers and Majluf (1984) and presents an empirical analysis of M&A announcement effects differentiated by method of payment. For acquisitions of publicly traded firms, large differences are observed depending on the financing, with equity offers exhibiting much larger negative announcement effects. Hansen (1987) theoretically explores the twin adverse selection effects of a seller having superior information about its asset value and the buyer having superior information about the value of the securities to be issued. Empirically, Hansen (1987) finds that the probability of a stock offer increases with the buyer’s debt and decreases with the buyer’s total assets.]

A. Corporate Control

Bidders controlled by a major shareholder may be reluctant to use stocks when that causes the controlling owner to risk a loss of control (Amihud, Lev, and Travlos, 1990, Stulz, 1988, Jung, Kim and Stulz, 1996). Assuming control is valuable, the presence of dominant shareholders positions will thus be associated with a more frequent use of cash, especially when a controlling shareholder’s position is likely to be threatened. To capture this effect, we use the ultimate voting stake held by the largest controlling shareholder (CONTROL). For example, if a family owns 50% of Firm X that owns 20% of Firm Y, then this family controls 20% of Firm Y (the weakest link along the control chain). This variable comes from Faccio and Lang (2002), and captures complex ownership structure including dual–class shares, pyramids, and cross–holdings.

A buyer with diffuse ownership or highly concentrated ownership is unlikely to be concerned with corporate control issues. In line with this argument, Martin (1996) documents a significantly negative relationship between managerial ownership and the likelihood of stock financing only for intermediate ranges of ownership. Similar evidence is reported in Ghosh and Ruland (1998). Therefore, we incorporate the possibility of a non–linear relationship between the method of payment and the voting rights of the bidder’s controlling shareholder. For this purpose, we include CONTROL > 40% and CONTROL > 60%, dummies that take value 1 if the controlling owner controls at least 40 (60) percent of votes, and zero otherwise.

B. Collateral, Debt Capacity and Excess Cash

We primarily use the fraction of tangible assets to measure a bidder’s ability to pay cash, financed from additional borrowing. COLLATERAL is measured by the ratio of property, plant and equipment (PPE) to book value of total assets. Myers (1984) pecking order model predicts that firms will finance investments first with cash, then with debt and only as a last resort with stock. In addition Myers (1977) argues that debtholders in firms with fewer tangible assets and more growth opportunities are subject to greater moral hazard risk, which increases the cost of debt. Hovakimian, Opler and Titman (2001) find that a firm’s percentage of tangible assets strongly influences its debt level. If external financing is more costly than internal financing, then firms should prefer to first use their cash reserves for investment expenditures. Jensen (1986) argues that bidders with excess cash or more generally high free cash flows are more likely to finance acquisitions with cash, which do not require financial intermediary and outside investor evaluation. Hartford (2001) documents that U.S. buyers tend to have large amounts of cash and free cash flow prior to their acquisitions.

C. Bidder Size

Bidder size is likely to influence its financing choices. Larger firms have proportionally lower bankruptcy costs.[1] They also have lower flotation costs and are likely to have better access to debt markets, making debt financing more readily available. Thus, larger firms should find cash financed acquisitions more feasible given their ability to issue debt. Larger firms are also more apt to choose cash financing in smaller deals given the scale economies in issuing securities and the significant costs associated with obtaining shareholder approval for preemptive rights exemptions. We use the (log of the) dollar size of the bidder, as measured by book value of total assets (TOTAL ASSETS).

Cash payments are less likely in large deals, especially when a buyer has limited liquid assets and unused debt capacity. On the other hand, as argued earlier, larger deals relative to buyer equity capitalization are likely to have a more serious dilution effect on the dominant shareholder’s control position if stock is used. Conditional on the buyer having unused debt capacity or liquid assets, cash is also simpler to execute for buyers in small deals. Furthermore, the use of cash allows the buyer to avoid shareholder approval of pre-emptive rights exemptions and stock authorizations. A deal’s dollar value (excluding assumed liabilities), DEAL VALUE, is measured by the log of dollar offer amount and also serves as a proxy for the target’s value.

D. Asymmetric Information and Overvalued Bidder Stock

Both Myers and Majluf (1984) and Hansen (1987) predict that bidders will prefer to finance with stock when they consider their stock overvalued by the market and prefer to finance with cash when they consider their stock undervalued. Martin (1996) finds evidence consistent with this prediction. We use as a proxy for bidder over or under valuation, RUN–UP, calculated from the bidder stock’s cumulative return over the year preceding the M&A announcement month.

Hansen’s (1987) model predicts that bidders would prefer to finance with stock when asymmetric information about target assets is high.[2] This could be the case, for example, when target assets are large relative to those of a bidder. We use REL SIZE as proxy for this effect. The relative size is computed as the ratio of acquisition’s offer amount (excluding assumed liabilities) to bidder market capitalization (*100). Furthermore, we would expect the fraction of stock financing to increase with a deal’s relative value because of impact of bidder liquidity and debt capacity constraints in large deals.

E. Deal Execution Speed

Cash enables more rapid deal completion, thus lessening the risk competitive bids and aggressive takeover defenses (Fishman, 1989). Gilson (1986) documents that stock payments lead to substantial delays in the US, due to security registration and shareholder approval requirements. Speed is particularly important when a bidder has a high valuation of the target.[3] Furthermore, cash lowers likelihood of bid rejection by target management (Fishman, 1989). To control for these hypotheses, we use UNFRIENDLY, a dummy that takes value of one if a deal is hostile, unsolicited or involves a white knight. This variable was first defined based on SDC data, and augmented with extensive searches on Lexis–Nexis.

F. Bidder and Deal Tax Benefits

Several countries allow tax exemptions in case of mergers (which are often financed with stocks). We use on the Economist Intelligence Unit’s Country Commerce Reports, to build the dummy variable, MERGER TAX BEN. This dummy variable takes a value of 2 if there is any tax advantage for mergers (vs. acquisitions) in both the target and bidder nations, a value 1 if there is a tax advantage in only one of the nations involved, and 0 if there is no tax advantage in either nation.

While controlling for all tax effects of M&A transactions is a nearly impossible task, we do include a control for the capital gains tax benefits of various financing methods.[4] We use a dummy variable, STOCKS TAX ADVANTAGED, to control for firms with individual and corporate capital gains treatment. This variable is based on information contained in the Economist Intelligence Unit’s Country Commerce Reports. This dummy takes value of one if there is any tax advantage to stock payments in the target’s country, and is zero otherwise.

The US tax code allows tax–free mergers and acquisitions, if at least fifty percent of the target’s shares are exchanged for stocks and other conditions are met. If the conditions for a tax–free deal are met, then the capital gain associated with the stock proportion of the purchase price can be tax deferred, while otherwise the entire purchase price is subject to taxation. Those offers will always include at least fifty percent of stocks, in order to take advantage of the tax benefits.[5]

For non–US targets the tax implications are much more varied. Most countries offer no tax advantage to equity financed M&A transactions. However, some countries provide exemptions. In Ireland, capital gains are normally taxed at the standard corporate rate. However, there are special roll–over provisions for business–related assets when sale proceeds are used to acquire new or similar assets within one year before or three years after the disposal date. In the UK, capital gains arising from acquisitions can normally be deferred if shareholders are compensated with shares or bonds rather than cash, provided the enlarged company continues in the same line of business. In addition, mergers create no taxable gains. If Canadian shareholders exchange shares for cash in a merger or takeover, they are taxed on the capital gain. However, acquisitions offering optional payment in cash or shares permit a tax–free rollover when shares are chosen. In Panama, no income tax is imposed on capital gains from sales of shares registered with the National Securities Commission if the sale results from a merger or corporate reorganization involving an exchange of shares.