In this article, we examine acquiring companies’ cash flow performance after a merger in the fifty largest U.S. industrial takeovers from 1979 to mid-1984. In an earlier study, we showed that the mergers in this same sample created new value for the stockholders of the target company and the acquiring company combined.1 But our results here show that the acquirers did not generate any additional cash flows beyond those required to recover the premium paid. However, while the takeovers were break-even investments on average, the profitability of the individual transactions varied widely.
There were two distinct types of takeovers in our sample: (1) friendly transactions that typically involved stock payment for firms in overlapping businesses, which we called “strategic” takeovers; and (2) hostile transactions that generally involved cash payments for firms in unrelated businesses, which we labeled “financial” takeovers.2
Strategic takeovers have several potential advantages over financial transactions. Because they combine firms in related businesses, strategic transactions are likely to offer greater business synergies than financial transactions. Acquiring managers in friendly strategic takeovers are more familiar with the target company’s business and have access to proprietary information in negotiations, which improves their accuracy in valuing the target. Further, stock-financed transactions reduce the cost of valuation mistakes because the stockholders of the target company partially bear some of the consequences of the errors. Finally, friendly takeovers are less likely to experience disrupted operations after the takeover that may destroy the target firm’s intangible assets. For all these reasons, some cite strategic takeovers as potentially more profitable than financial transactions.
On the other hand, if friendly strategic takeovers are manifestations of free cash flow problems, they are likely to be less profitable than financial transactions, which replace inefficient management and reduce agency costs.
Our study results show that strategic takeovers generated substantial gains for acquirers. Financial transactions broke even at best. The premiums in strategic takeovers were lower than in financial deals and the synergies were higher, indicating that strategic acquirers were able to pay less to get more.
We also examine the relation between the profitability of takeover transactions and three transaction characteristics that management controlled.3 Those characteristics were: (1) the target managers’ attitude, (2) the form of payment, and (3) the degree of overlap of the merging firms’ businesses.