Creating wealth through mergers in Canada.

ABSTRACT

Using financial event study method, we examine the impact of merger announcements on shareholder wealth of Canadian companies during an exceptional worldwide merger boom. Our results show that both target companies and the acquirer companies earn significant positive abnormal returns in the short term. However, beyond five days after the event, we observe that abnormal returns diminish to become significant and negative for acquiring companies and diminish to be non-significant and positive for target companies. Consistent with previous Canadian studies, merger announcements have positive signaling effects on stock performance. Our large sample study updates and fills a void in Canadian merger studies during this important and recent time period in merger and acquisitions.

1. INTRODUCTION

The current decade has been an extraordinary period to study mergers unlike any other periods studied in the finance literature. That is, since the 1980's decade of merger activity, there has been a worldwide merger boom. (Pryor, 2001) characterizes this merger boom in the 1990's as a distinct decade of mergers from the 1980's in the US, Canada and OECD countries. Indeed, in the 1990's, we witness some spectacular merger activities such as the frenetic initial public offerings and subsequent acquisitions of multitudes of dot.com companies, the prominence of global business and transnational mergers, and unprecedented mega-merger deals such as the 165 billion AOL-Time Warner deal. Quantitatively, (Pryor,2001) estimates that between 1992 and 1999, the total recorded value of merger deals grew at an annual rate of 35.7 percent, and from 1985 to 1999, the total volume of mergers rose at 20.8 percent annually. He notes that this merger boom is much greater (measured in terms of number) than previous merger booms with peaks around 1900, 1929, 1963 and the early 1980's (Golbe and White, 1993). Finally, to truly understand the exceptional nature of this merger boom, (Pryor,2001) finds this merger boom to be greater than any other merger boom in past U.S. history.

The study of mergers and acquisitions focuses on understanding what motivates managers to engage in this type of activity and the impact that mergers and acquisitions have on shareholder returns. Mergers and acquisitions are an important means to grow a company. Managers' motivations for mergers could be empire building through growth in size, (Mueller, 1969) sales and assets (Berle and Means, 1932), (Schipper and Thompson, 1983). Managers choose to merge or acquire with others for potential market gains, for overcoming technological barriers, and for gaining a technological edge, as well as for building diversification on existing strengths. Managers are also pursuing efficiency improvements through mergers and acquisitions. Efficiency improvements can be gained from synergy of target and bidding firms due to economies of scale and use of excess capacity. For example, vertical mergers create economies of scale by enabling more efficient coordination of the members of the vertical chain. (Berry, 2000) and (Williamson, 1971) further promotes that vertical mergers increase shareholder returns by creating internal transfer pricing transactions. Managers may pursue mergers and acquisitions to lower the cost of capital and improve shareholder returns. They may see that acquisitions can reduce the probability of default due to the co-insurance effect (Lewellen, 1971) thus reducing bankruptcy costs and increasing the debt capacity of the combined firm. By increasing debt capacity, a manager can reduce the cost of capital through interest tax shields and add value to the firm. (Levy and Sarnat, 1970) support this managerial motivation. They find that in conglomerate mergers, large firms enjoy significant cost savings when securing their financing needs. These cost savings presumably reflect, at least in part, the reduction in lenders' risk achieved through diversification. However, recent studies [(Lang and Stulz,1994), (Berger and Ofek, 1995), (Maquieira, Megginson and Nail, 1998)] challenge value creation in conglomerate mergers; that there are no synergies created through diversification or horizontal mergers.

For the above motivations and more, Canadian managers are very active in mergers and acquisitions between 1994 and 2000. In this paper, we examine the impact of mergers on shareholder wealth of Canadian companies.

The first contribution of this paper is to examine current return patterns after a merger given the extraordinary period of this worldwide merger boom. (Henry,2002) reports that nearly $4 trillion worth of mergers were done from 1998 through 2000--more than in the preceding 30 years. Indeed, such changes are anticipated as the literature has noticed temporal effects on M&A performance.

Moreover, there are very few current studies on Canadian M&A, and the key studies date back to the 1980's. Like the U.S., Canadian managers are very active in mergers and acquisitions between 1990 and 2000. In contrast to US studies of shareholder returns, Canadian studies appear to consistently show positive and significant returns to acquiring firm shareholders. Yet, the Canadian studies are few and more evidence is needed; this paper provides the most current evidence. Differences in Canadian industry, capital markets and regulations appear to justify the difference in the Canadian experience. While the Canadian merger studies show similarities with U.S. findings, there are differences between Canadian companies, markets and regulations and their U.S. counterparts to justify this study. This paper as a Canadian study would be generalizable because of the similarities and contribute new findings because of the differences. It will serve to fill a void in the empirical work in Canada that is largely done in the 1980's to gain insight of the largest worldwide merger boom in history.

The first part of the paper summarizes the key research findings from the literature on mergers and acquisitions. We then formulate our hypotheses, describe the sample of firms, data acquisition, and analytical methodology and present our results. We conclude the paper with a discussion of directions for further research.

2. LITERATURE REVIEW

Most financial research in mergers and acquisitions use event study method to examine the impact of merger announcements on stock prices. Various researchers [(Dodd, 1980), (Dennis and McConnell, 1986)] conclude that as a result of merger, the returns go to target firms. Returns to target shareholders range from 20-30 % [(Dodd and Ruback, 1977), (Dodd, 1980), (Bradley and Wakeman, 1983), (Jensen and Ruback, 1983), (Malatesta, 1983)]. On the other hand, the impact of merger on returns for the acquiring firms has largely been either significant negative abnormal returns [(Dodd, 1980), (Firth, 1980), and (Eger, 1983)] or non-significant positive abnormal returns [(Asquith, 1983), (Eckbo, 1983), (Dennis and McConnell, 1986) and (Amihud, Dodd and Weinstein, 1986)].

Over time, short-term event studies do consistently find that the nature of the merger deal create gains and losses for acquirers. How the deal is made as a friendly merger or hostile takeover, or how it is paid for through stock or cash does matter. Indeed, managers pursuing mergers can make decisions on how the merger deal is executed to materially influence the profitability of the merger.

The method of merger has an impact on shareholder returns. Tender offers are made directly to company shareholders for a controlling stake of the company. These tend to be unfriendly takeovers. Merger offers are negotiated between top management of the acquiring and target companies; these tend to be friendly takeovers (Bruner, 2002). (Jensen and Ruback,1983) find that shareholders of target firms in tender offers receive about twice the returns of those receiving merger offers. Tender offers do pay.

(Travlos, 1987) studies the impact of form of payment made by an acquiring firm on shareholder returns in a merger. He finds significant differences in abnormal returns between acquirers making stock-exchange offers versus cash offers. That is, acquirers making cash offers achieve normal returns; whereas, acquirers making stock-exchange offers achieve abnormal negative returns. (Franks, Harris and Mayer, 1988) explain "equity in acquisitions conveys bad news, while cash conveys good news". Indeed, (Travlos, 1987) also supports this information signaling hypotheses to explain different returns for acquiring firms making cash offers versus stock offers.

While most event studies on the impact of mergers on shareholder returns are done in North America, there is also similar evidence around the world. (Doukas and Travlos, 1988) examine the impact of international mergers and acquisitions on U.S. company shareholder returns. Their findings are interesting because studies on domestic acquisitions often find non-significant positive returns for the acquiring firm; it is the target firm that receives the abnormal returns. In contrast, they find that when a U.S. company acquires a company in another country, significant and positive returns are gained. These abnormal returns are larger when firms expand into new industry and geographic markets--especially with those countries that are less developed than the U.S. economy. Further research of (Manzon, Sharp and Travlos, 1994) find that the abnormal returns to U.S. companies making international acquisitions are related to tax differences in the international tax status of acquiring firms.

Looking at foreign companies buying U.S. companies, such mergers and acquisitions result in significant and positive returns to shareholders of both acquiring and target company shareholders (Eun, Kolodny, and Scheraga, 1996). Shareholders of the U.S. target companies earn significant wealth gains regardless of the nationality of foreign acquirers. In particular, their study show that Japanese acquisitions generate the largest wealth gains to both target and acquiring company shareholders. A compelling motivation for foreign managers was gaining the U.S. target firms R&D capabilities and access to a more lucrative US market. (Lyroudi et al., 1999) examine 50 international acquisitions by European and Japanese firms between 1989-91. They find that within an event study period of five days before and after the mergers, the abnormal returns to the acquiring firms are zero.

The Canadian experience of merger studies date back to 1983. Consistent with the research on mergers and acquisitions in the United States, Canadian studies also show that target firms gain more than acquirers. On average, gains are 9-23% for target firms. (Eckbo,1986), (Calvet and Lefoll, 1987) using Canadian monthly data, find that mergers result in significant gains for shareholders of acquiring and target firms. (Masse, Hanrahan and Kushner, 1988), using daily data, find that the timing of the gains is focused in the month prior to the merger announcement date. (Masse, Hanrahan and Kushner, 1990) conclude that the type of acquisition and method of payment do affect the shareholder returns for both the target and acquiring firms. They find shareholders of both target and acquiring companies receive gains. Shareholders of acquiring firms earn considerably less returns than those of target firms, both in tender and in merger offers. For target firms, tender offers pay double the returns to shareholders than merger offers. The previous studies do show similarities in results with U.S. studies. Yet, Canadian studies and the industry do differ from the U.S. for these important respects. First, studies in Canada report positive and significant gains to acquiring companies; whereas, most merger studies on US companies report significant negative or non-significant returns to acquiring companies (Bruner, 2002). Second, Canadian capital markets, industries and companies are much smaller than the US. Canada is about one tenth the size in population as the United States. Third, "Canadian industrial markets are characterized by fewer firms and greater concentration of output relative to the U.S. markets" (Eckbo, 1992). He finds that the mean industry concentration ratio is 48% in Canada and 33% in the U.S. for horizontal mergers. Fourth, merger and acquisition regulations are more developed and strict in the U.S. compared to Canada. (Bruner, 2002) concludes from five studies that "M&A regulation is costly to investors." For example, (Shipper and Thompson, 1983) consider four regulatory changes between 1968 and 1970 and find wealth-reducing effects associated with increased regulation. (Eckbo, 1992) points out that the enforcement of anti-trust policy since the 1950's "significantly deter horizontal merger activity" in the United States. On the other hand, Canada has fewer regulations on mergers and acquisitions. (Woods,1992) reports that the Canadian notion of anti-competitive conduct is less strict than its American counterpart and treble damages are not available. Hence, for the reasons that Canadian and U.S. industry, capital markets and regulations do differ, that Canadian studies on M&A are justifiably different from U.S. studies. Yet, there are similarities; as the world's largest trading partners, the capital markets of Canada and U.S. are more related with each other than with other countries. Both countries are tied together by the NAFTA agreement made since 1994. Canadian and U.S. companies share a similar business culture, are geographically North American, and many cross-border mergers and exchange listings exist. This study on Canadian mergers would be generalizable because of the similarities and contribute because of the differences that Canadian studies have with U.S. studies.

Given this extraordinary period of mergers in the 1990's, there is reason to believe in changes in the return patterns to acquirer and target companies over time. (Bruner, 2002) observes that there is "a slight tendency for returns to decline over time: returns appear to be higher (more positive) in the 1960's and 1970's than in the 1980's and 1990's, except for deals in technology and banking, where returns to bidders increase in the 1990s." As is also reported by (Bradley, Desai and Kim, 1988) that average announcement returns to acquirers fell from 4.1% in the 1963 to 1968 period, to -2.9% in the 1981-1984 period. These suggest that there is a temporal effect on M&A performance. While there are numerous empirical studies done in the 1990's in the U.S., there are few done in Canada between 1990-2001. These few studies deserve mention; there are two. (Eckbo, 1992) uses Canadian merger data from 1964 to 1982 in his article, "Mergers and the Value of Antitrust Deterrence". (Jabbour, Jalilvand, and Switzer, 2000) uses Canadian merger data from 1985-1995 in their article, "Pre-bid price run-ups and insider trading activity: Evidence from Canadian acquisitions". Our paper examines a sample period of 1994-2000. In times of a merger boom, we hypothesize that mergers and acquisitions create significant and positive returns to shareholders of both acquirer and target companies. There is money to be made in mergers during this booming and prosperous period of mergers unlike other time periods. Many previous studies report significant and negative returns or non-significant returns to acquiring company shareholders. Our paper serves to fill a void in the empirical work in Canada that are largely done in the 1980's to gain insight of a unique worldwide merger boom that occurred between 1985 and the end of the millennium.

3. METHODOLOGY

3.1 Hypotheses Testing

We test the following hypotheses for the merger announcements:

First we examine whether mergers and acquisitions create abnormal returns for the target company shareholders:

   [H.sub.1]: Ha = Mergers and acquisitions do create positive and
   significant abnormal returns for target company shareholders.

Second, we test whether mergers and acquisitions create abnormal returns for the acquiring companies:

   [H.sub.2]: Ha = Mergers and acquisitions do create significant and
   positive or negative abnormal returns for acquiring company
   shareholders.

We examine the short-term (40 day) performance of Canadian mergers between 1994-2000. All Canadian mergers over this 6-year period are examined. The announcement dates, as well as auditor, investment banker and issue specific information is obtained from the Lexus Nexus database. As a basic criterion, companies first have to be publicly traded and have sufficient time series price data on Datastream. Some data are screened out because of the following reasons: 1- The stock is in the regional market, 2- the stock has not traded continuously, and 3- the companies are in the financial industry. Financial firms experience different return patterns than those of non-financial companies. Table I summarizes the number of companies examined in our sample.

As shown in Table I, as a result of meeting our criteria, we are able to calculate returns on 1361 acquirer companies and 242 target companies. We acknowledge that there are far more Canadian acquiring companies compared with target companies. The percent positive returns shows the percentage of acquiring and target companies that show positive returns during the merger period of first two days after the announcement. It appears that more target company shareholders earn positive returns compared with acquiring company shareholders.

The paper utilizes standard event study method and calculates abnormal returns around merger announcements to shareholders. The Toronto Stock Market Composite Total Return Index (TSE-300) is also obtained from the DataStream database. We calculate returns using as follows:

[R.sub.it] = Ln ([P.sub.it]/[P.sub.it-1]) where [R.sub.it]: the return on security i during day t [P.sub.it]: the adjusted closing price of security i on day t

The daily excess return for a security is estimated by :

[e.sub.it] = [R.sub.it] - E([R.sub.it]) where [e.sub.it]: the excess return to security i for day t E([R.sub.it]) : the expected rate of return on security i on day t

E([R.sub.it]) is found by using the equation of:

E([R.sub.it]) = a + b[R.sub.mt] where [R.sub.mt]: the market return during day t

We regress daily returns ([R.sub.it]) on daily market returns ([R.sub.mt]) to find a and b values by using [-200 days, -50 days] data of return on each stock and return on the TSE index with regression analysis. The average excess return on a portfolio of N securities for day t is the equally weighted arithmetic average of excess returns:

A[R.sub.t] = 1/N * [summation of] [e.sub.it]

Daily average cumulative excess returns, CAR, are formed by summing the average excess returns over event time where the CAR period is for various different periods.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

3.2 Analysis

To accept or reject our hypotheses in this event study, we use the t-statistic to test for significance at the alpha = .05 level. In our first hypothesis, we hypothesize that targets will earn positive abnormal returns given that most studies have found this result. Consequently, we perform a one-tail t-test on our abnormal returns for significant differences. Because previous studies show that acquirers earn negative or positive returns, we perform a two-tail t-test on abnormal returns for significant differences.

4. RESULTS AND INTERPRETATION

4.1 Performance of Target Firms

We examine abnormal returns for 242 target companies' shareholders between 1994 and 2000 as shown in Table II and cumulative abnormal returns for the same shareholders in Table III. We find that target firm shareholders start earning significant excess returns as early as 2 weeks, on days -14 and -16 before the merger announcement day. Three days before the announcement day, the abnormal returns are also significant and positive at 0.96%. The abnormal returns are 0.57 and 0.82% respectively on days -2 and -1; however, they are statistically non-significant. However, on the day of announcement, a significant and relatively large abnormal return is found, which is 4.42% mean abnormal return to target shareholders. There is also significant positive abnormal return, 1.19% two days after the announcement day.

As shown in Table III and Figure 1, our holding period returns or Cumulative Abnormal Returns (CAR), also support our alternate hypothesis that significant and positive abnormal returns go to target shareholders. The significant and positive CAR's have a range from 4.00 percent to 9.53 percent. The cumulative abnormal return for target companies within two day holding period (CAR 0,2) is 6.31%, and this number goes as high as 8.73% for ten day holding period (CAR-5,5) beginning 5 days before the announcement day. Ten-day holding period starting from the announcement period (CAR 0,10) produces 4.00% abnormal return. Abnormal returns become non-significant for a three-week horizon; however, they never become negative for target company shareholders.

[FIGURE 1 OMITTED]

4.2 Performance of Acquiring Firms

We find abnormal returns for 1361 acquiring companies' shareholders as shown in Table IV and cumulative abnormal returns for the same shareholders in Table V and Figure 2. Our evidence supports positive abnormal returns. Abnormal returns start to be significant two days before the announcement. On the announcement day, shareholders of the acquirers experience 1.09% positive excess return. Shareholders continue their earnings with 0.53% excess return the day after the announcement. Two days after the takeover announcement shareholder returns turn into negative range, although negative returns become significant only four days after the announcement.

As shown in Table V and Figure 2, our holding period returns or Cumulative Abnormal Returns (CAR), also justify our alternate hypothesis that significant and positive abnormal returns go to acquirer shareholders in the first week. The shareholders of the acquiring firms earn a total of 2.01% excess returns within days -2 and +2. Between the announcement day and the 2 days after (CAR 0,2), they earn 1.41%. However after the first week returns become negative. These abnormal returns become non-significant at the end of the first week and significant and negative at three weeks and four weeks.

[FIGURE 2 OMITTED]

5. CONCLUSION

We investigate the announcement effects of mergers and acquisitions on shareholders' returns between 1994 and 2000. Our results show that both the target and the acquiring company shareholders earn significant and positive abnormal returns for two-day holding period starting with the announcement day.

In the context of a worldwide merger boom during the 1990's, we find that mergers and acquisitions have benefited both target and acquirer company shareholders. Consistent with previous Canadian studies, merger announcements have positive signaling effects on stock performance. Despite the merger boom, the CAR returns of 9.53% to target shareholders that we find do not compare as high as the returns found in previous Canadian studies, which ranged from 9 to 23 percent. Our acquirer sample of 1361 acquiring companies is the largest sample for Canadian merger studies. While we report positive abnormal returns for acquiring shareholders during the announcement, these positive returns are fleeting beyond five days after the announcement. Returns after which become significant losses for acquiring shareholders. This too, is similar with studies reporting significant negative returns to acquiring shareholders. For the business practitioner, creating value through acquisition requires an understanding of what truly creates value and the ability to realize value paramount. (Bruner,2002) suggests "value is created by focus, relatedness and adherence to strategy."

Reflecting on some limitations of this study allows us to give direction to future research. One limitation is that we do not examine the impact of cash and stock payment on the different returns to acquirers. In the future, we will examine other explanatory variables on shareholder returns such as method of payment, type of merger, and financial performance.

The consistent findings of gains to acquirers and targets found in Canadian studies still support the US studies and continue to be generalizable because there are also similarities between Canadian and US capital markets. Limits to generalizability of these findings include: Canada being a different country having different capital markets and a different time period. We find that these differences justify our pursuit of this study. Indeed, other countries undoubtedly have differences in capital markets, industry characteristics and regulations that pertain to mergers just like Canada does with the United States. Hence, this study is generalizable to the extent that such country differences do affect the impact of mergers on returns. This paper provides a comprehensive update of the Canadian merger literature during this important period of 1994-2000.

TABLE I.
SAMPLE STATISTICS OF CANADIAN PUBLIC COMPANIES
IN MERGERS AND ACQUISITIONS, 1994-2000

                                     Acquiring        Target
                                     Companies      Companies

Total Number of Listed Companies   1565            281
Less Financial Service Companies   -204            -39
Number of Companies Reported       1361            242
Average Transaction Value          $150,005,434    $284,143,753
Percent Positive Returns           53% (CAR 0,2)   61%
                                   41%(CAR0,30)

TABLE II.
TARGET COMPANY ABNORMAL RETURNS

Event   Abnormal                 Event   Abnormal
Day     Return     t-statistic   Day     Return     t-statistic

-20     0.40%      0.85          1       0.70%      1.14
-19     -0.17%     -0.41         2       1.19%      2.33 *
-18     -0.17%     -0.36         3       -0.63%     -1.30
-17     -0.77%     -1.45         4       0.38%      0.84
-16     0.92%      2.20 *        5       -0.40%     -0.86
-15     0.18%      0.44          6       -0.22%     -0.58
-14     0.90%      2.02 *        7       -0.15%     -0.40
-13     -0.36%     -0.73         8       0.26%      0.76
-12     0.47%      1.17          9       -0.61%     -1.35
-11     0.61%      1.14          10      -0.94%     -0.73
-10     -0.63%     -1.48         11      -0.92%     -1.91
-9      0.79%      1.84 *        12      0.07%      0.18
-8      0.19%      0.49          13      -0.17%     -0.42
-7      0.10%      0.31          14      0.28%      0.76
-6      -0.01%     -0.03         15      0.41%      1.19
-5      0.81%      1.82 *        16      -0.05%     -0.12
-4      -0.08%     -0.20         17      -0.19%     -0.43
-3      0.96%      2.06 *        18      -0.14%     -0.35
-2      0.57%      1.26          19      -0.40%     -1.16
-1      0.82%      1.66 *        20      0.20%      0.58
0       4.42%      3.85 *

* = Statistically
significant at 0.05
level or less for a
one-sided t-test

Table III.
Target Company Cumulative Abnormal Returns

              Abnormal
CAR Range     Return     t statistic

CAR(-5,5)     8.73%      4.832 *
CAR(-2,2)     7.69%      5.131 *
CAR(0,2)      6.31%      4.676 *
CAR(0,5)      5.66%      3.600 *
CAR(0,10)     4.00%      1.989 *
CAR(0,20)     3.09%      1.315
CAR(0,30)     2.01%      0.728
CAR(-10,10)   7.51%      3.131 *
CAR(-40,40)   9.53%      2.190 *

* = Statistically
significant at 0.05
level or less for a
one-sided t-test

TABLE IV.
ACQUIRER COMPANY ABNORMAL RETURNS

Event   Abnormal                 Event   Abnormal
Day     Return     t-statistic   Day     Return     t-statistic

-20     -0.16%     -0.733        1       0.53%      3.148 *
-19     0.34%      1.208         2       -0.21%     -1.430
-18     -0.01%     -0.076        3       -0.27%     -1.598
-17     -0.11%     -0.590        4       -0.44%     -2.977 *
-16     0.08%      0.523         5       -0.32%     -2.620 *
-15     0.03%      0.186         6       0.02%      0.139
-14     0.07%      0.368         7       -0.38%     -2.595 *
-13     0.32%      1.463         8       -0.41%     -2.794 *
-12     0.17%      1.380         9       0.09%      0.702
-11     0.10%      0.741         10      -0.46%     -3.105 *
-10     0.09%      0.431         11      0.09%      0.489
-9      0.02%      0.099         12      -0.16%     -1.256
-8      -0.08%     -0.657        13      0.02%      0.172
-7      0.20%      1.427         14      -0.15%     -1.110
-6      0.03%      0.227         15      -0.40%     -2.778 *
-5      0.19%      1.294         16      -0.22%     -1.644
-4      0.09%      0.694         17      -0.06%     -0.418
-3      0.00%      -0.012        18      -0.06%     -0.454
-2      0.35%      2.226 *       19      -0.15%     -1.009
-1      0.25%      1.547         20      0.21%      1.301
0       1.09%      4.650 *

* = Statistically
significant at 0.05
level or less for a
one-sided t-test

TABLE V.
ACQUIRER COMPANY CUMULATIVE ABNORMAL RETURNS

              Abnormal
CAR Range     Return     t statistic

CAR(-5,5)     1.27%      2.869 *
CAR(-2,2)     2.01%      4.919 *
CAR(0,2)      1.41%      4.764 *
CAR(0,5)      0.39%      1.113
CAR(0,10)     -0.76%     -1.689
CAR(0,20)     -1.63%     -2.269
CAR(0,30)     -3.73%     -3.653*
CAR(-10,10)   0.38%      0.618
CAR(-40,40)   -2.32%     -0.960

* = Statistically
significant at 0.05
level or less for a
two-sided t-test

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Alex Ng is earning his doctorate at Nova Southeastern University, Florida. Currently he is a lecturer of finance at the University of Northern British Columbia.

Dr Ayse Yuce earned her PhD. at Louisiana State University in 1994. Currently she is an associate professor of finance at Ryerson University.