Research Series #2: Impact of the Acquisition Method

The impact of the acquisition method on the annual reports of target companies

A paper by Campa and Hajbaba shows that the payment method used in financing an acquisition has an impact on the earnings manipulation incentives of target firms.

Analyses on Mergers and Acquisitions (M&A) activities of companies show that, on average, acquirers underperform subsequent to the takeover completion. The current debate recognized several reasons for this underperformance and, most of them, link such a negative post-acquisition performance to an overpayment for targets at the time of acquisition announcement.

Is it possible that such an overpayment is linked to a “too optimistic” performance of target firms?

A research from Campa and Hajbaba, published in the International Review of Financial Analysis, aimed to answer this question by analyzing whether acquirers’ post-takeover negative abnormal return is associated with target firms’ overestimation of their financial performance through earnings manipulation, taking into account the payment method chosen for acquisition.

Indeed, an acquirer can finance an acquisition in three ways: acquirer’s shares, cash, or a combination of shares and cash. Taking the payment method into account is relevant because, in an equity-financed takeover, targets and acquirers’ shareholders share the risk of the outcome of the acquisition since they both become owners of the new business combination.

Therefore, in an equity-financed takeover, any targets’ effort to overestimate their value could negatively impact their shareholders’ wealth, post-takeover, if such an overvaluation is detected and corrected by the market. This raises the question about whether targets have incentives to manipulate earnings when the acquisition is financed by any means of payment other than cash.

The analysis proposed by the authors indicates that when target firms share the risk of acquirer’s overvaluation (i.e. in equity- or hybrid-financed M&As) they do not manipulate earnings. However, their analyses also reveal that in cash-financed acquisitions, target firms tend to overestimate their operating performance, in order to extract the maximum price from it without being affected by any potential subsequent negative market correction.

In conclusion, with this research, the authors indicate that the method of financing an acquisition could be a determining factor of the level of earnings management in target firms. In particular, when a deal is done by cash, target firms have the incentives to opportunistically increase earnings in order to extract the maximum price from the deal and “disappear” once the market discovers and corrects such an overvaluation. They also emphasize the fact that such an income-increasing earnings manipulation is carried out through real transactions rather than the use of the accruals to minimize the risk that a due diligence reveals such practices.

Detail of the paper:

Campa D., Hajbaba H., (2016), Do Targets Grab the Cash in Takeovers: the Role of Earnings Management, International Review of Financial Analysis, Vol 44, pp. 56-64. DOI:10.1016/j.irfa.2016.01.008.