Mergers Can Be Risky Business

“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.

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.

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