Mergers Can Be Risky Business
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Finance & Accounting Nov 30, 2011

Mergers Can Be Risky Business

Default risk rises for acquiring firms

Based on the research of

Craig Furfine

Richard J. Rosen

When one company merges with another, common business wisdom suggests that the newly combined firm has a lower risk of going into default, because the transaction gives the merged corporation greater diversity than the two individual participants. But according to a study by Craig Furfine, a clinical professor of finance at the Kellogg School of Management, and Richard Rosen, of the Federal Reserve Bank of Chicago, that common wisdom is wrong. “On average,” Furfine says, “acquiring firms become riskier post-merger.”

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The nat­ur­al intu­ition that many peo­ple would have is that when you com­bine two firms, the dif­fer­ences between the two firms would tend to make the com­bined firm safer through diver­si­fi­ca­tion,” Furfine explains. This is not what hap­pens in practice.”

The study goes beyond that coun­ter­in­tu­itive con­clu­sion. It also high­lights pos­si­ble rea­sons for it. Our evi­dence sug­gests that man­age­r­i­al moti­va­tions may play an impor­tant role,” the two researchers write. “[T]he increased default risk may arise from aggres­sive man­age­r­i­al actions affect­ing risk enough to out­weigh the strong risk-reduc­ing asset diver­si­fi­ca­tion expect­ed from a typ­i­cal merger.”

Those unex­pect­ed con­clu­sions emerged in large mea­sure because Furfine and Rosen viewed merg­ers through a dif­fer­ent lens. Most of the aca­d­e­m­ic research on cor­po­rate merg­ers has focused on address­ing the ques­tions Why do firms merge?’ and Do merg­ers cre­ate val­ue, and if so, for whom?’,” Furfine says. Our basic objec­tive was to look at cor­po­rate merg­ers from a dif­fer­ent angle: an acqui­si­tion not only affects a firm’s poten­tial return stream but also changes the firm’s risk, includ­ing its chances of going bankrupt.”

An Unfa­mil­iar Ana­lyt­i­cal Tool
To under­take their inves­ti­ga­tion, the pair relied on a tool uncom­mon in aca­d­e­m­ic stud­ies: the Expect­ed Default Fre­quen­cy (EDF) devel­oped by Moody’s KMV. This pro­vides an esti­mate of the prob­a­bil­i­ty that a par­tic­u­lar firm will default with­in a year. Because it is rather expen­sive, aca­d­e­mics don’t typ­i­cal­ly con­sid­er using it,” Furfine says. But it has great val­ue in cal­cu­lat­ing the fate of firms in dan­ger of default. The data­base cal­cu­lates how far a firm is from default using tra­di­tion­al meth­ods. Its advan­tage is that it then cal­cu­lates from its his­tor­i­cal data­base how often firms that far from default actu­al­ly default in the next year.” Because they are based on his­tor­i­cal evi­dence, he adds, EDFs can be more accu­rate than tra­di­tion­al meth­ods of mea­sur­ing the risk of default.”

The two researchers applied the EDF data to infor­ma­tion in the Secu­ri­ties Data Corporation’s Merg­er data­base on firms that com­plet­ed merg­ers between Jan­u­ary 1, 1994 and March 31, 2006. Ancil­lary data on the acquir­ing firms’ stock returns and changes in their bal­ance sheets came from CRSP and Compustat.

Mix­ing, match­ing, and apply­ing basic busi­ness math­e­mat­ics to data from the three sources revealed the rela­tion­ship between merg­ers and default risk. Specif­i­cal­ly, the num­bers showed a mean increase of 0.519 per­cent in default prob­a­bil­i­ty for the 3,604 merg­ers that the pair explored. Although that may be viewed as incon­se­quen­tial for the riski­est of acquir­ers,” Furfine and Rosen write, it would imply mul­ti­ple down­grades for a high­ly rat­ed acquirer.”

What Caus­es the Added Risk?
Hav­ing estab­lished the unex­pect­ed rela­tion­ship between merg­ers and default risk, the pair set out to find its cause. Sug­gest­ed rea­sons include the trans­fer of risk from the tar­get com­pa­ny to the acquir­ing firm, an increase in finan­cial lever­age by the acquir­ing com­pa­ny, and the like­li­hood that merg­ers gen­er­al­ly take place when the risk that firms will default is increas­ing in the over­all econ­o­my. But care­ful analy­sis per­suad­ed the researchers that none of those rea­sons could account for the increased risk of default.

We haven’t nec­es­sar­i­ly dis­cov­ered why risk goes up in aver­age,” Furfine adds. We’ve dis­cov­ered why it goes up in some cas­es more than oth­er cases.”

That analy­sis also dis­missed one oth­er poten­tial rea­son for the extra risk. Our results indi­cate that risk-increas­ing merg­ers are not the result of acqui­si­tions facil­i­tat­ed by over­val­ued stock,” the paper reports. After con­trol­ling for oth­er fac­tors, merg­ers financed with stock tend to be cor­re­lat­ed with risk reduc­tion, sug­gest­ing that using stock as pay­ment may reduce the need to issue debt post-merger.”

Three Crit­i­cal Fac­tors
In response, the researchers sought a dif­fer­ent cause. When the obvi­ous expla­na­tions didn’t seem to be right, we start­ed to look at things like man­age­r­i­al moti­va­tions,” Furfine says. When man­agers know more than share­hold­ers, they have the abil­i­ty to act in ways that ben­e­fit them. This sug­gests that man­agers some­times act in their own interest.”

The authors found that three oth­er fac­tors asso­ci­at­ed with acquir­ing firms emerged as indi­ca­tors of increased default risk fol­low­ing merg­ers. Firms with high lev­els of idio­syn­crat­ic risk — indi­cat­ed by volatil­i­ty of their stock prices in ways uncor­re­lat­ed with the over­all mar­ket — gen­er­al­ly have a larg­er default risk after an acqui­si­tion than before. The risk of default also increas­es more at firms where CEOs have a larg­er share of option-based com­pen­sa­tion. And merg­ers that end up with increased risk are pre­ced­ed by poor stock per­for­mance of the acquir­ing firm.

Each of the three char­ac­ter­is­tics we asso­ci­at­ed with risk-increas­ing merg­ers can be inter­pret­ed as con­sis­tent with the pri­vate ben­e­fits moti­va­tion for merg­ers,” Furfine and Rosen report. We haven’t nec­es­sar­i­ly dis­cov­ered why risk goes up in aver­age,” Furfine adds. We’ve dis­cov­ered why it goes up in some cas­es more than oth­er cases.”

Furfine details the take-away mes­sage from the study: Our paper’s main con­tri­bu­tion is to doc­u­ment that merg­ers, on aver­age, increase the default risk of the acquir­ing firm,” he says. Our find­ing that default risk increas­es is best explained by a firm’s idio­syn­crat­ic volatil­i­ty, option-based man­age­r­i­al com­pen­sa­tion, and poor acquir­er stock per­for­mance pre-merg­er sug­gests that man­age­r­i­al issues may be impor­tant.” Put more pith­ily, cor­po­rate man­agers some­times might be think­ing of their own needs, rather than those of their com­pa­ny and its share­hold­ers, when they deter­mine their com­pa­nies’ merg­er strategies.

Relat­ed read­ing on Kel­logg Insight

Super-Pre­mi­um Ice Cream: Merg­er effects on prod­uct variety

Pay­ing a Pre­mi­um on Your Pre­mi­um: Effects of con­sol­i­da­tion in the health insur­ance industry

About the Writer

Peter Gwynne is a freelance writer based in Sandwich, Mass.

About the Research

Furfine, Craig H., and Richard J. Rosen. 2011. “Mergers Increase Default Risk.” Journal of Corporate Finance. 17: 832-849.

Read the original

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