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Contrary to Wall St.'s thinking, high debt undermines corporate acquisitions

August 1, 2008

For more information, contact: Benjamin Haimowitz,

Is high debt an advantage in corporate acquisitions?
Although Warren Buffett is famously wary of it, he may very well be in the minority: not only is high debt common in acquisitions, but a large body of opinion in the finance literature views it favorably. High debt, it is argued, prevents managers from allocating resources unproductively; forces buyers to screen targets with more care than they would otherwise do; and exerts pressure on managers to perform well.
In support of this perspective, an influential study in the early 1990s found that high leverage in newly announced acquisitions was generally welcome on Wall Street and tended to boost the price of acquirers' shares.
Now a new study, to be presented at the annual meeting of the Academy of Management, in Anaheim, finds this earlier research to be only half right: yes, Wall Street's immediate response to high leverage in acquisitions does tend to be favorable; but, no, in the long run, high debt militates against the success of mergers, and Wall Street eventually comes to recognize as much.
"We conclude that the effect of high leverage when combined with acquisitions is negative over the long term," write the study's co-authors, Jeffrey S. Harrison of the University of Richmond and Derek K. Oler of Indiana University. "Managers and investors should avoid acquisitions that include highly leveraged acquiring firms or target firms or that will require significant new debt."
Noting that their research takes in more than 3,000 acquisitions over a 22-year period, Harrison and Oler describe their results as "very robust," citing "the size of the sample and number of controls" as bulwarks of their findings' credibility.
The principal reason for the negative impact of high debt, they argue, is that "the increased financial risk associated with high leverage, combined with the risks inherent in an acquisition itself, leads to a situation that is perceived as being so risk-laden that managers pursue non-value maximizing behaviors in an effort to reduce risk."
As Harrison explains, "When firms take on a lot of debt, it tends to make them risk-averse. Never is this more true than when the acquiring firm assumes big debts of the target: if the acquirer has debt, its leaders have been living with it; but anticipating the effect of a target's debt is another matter entirely. Due diligence notwithstanding, rarely do leaders grasp the extent to which a heavy load of new debt will change the way they view the world."
As for the vaunted disciplinary effect of leverage, the professor states, "There has been too much emphasis on that effect and not enough on the potential of high debt to inhibit the creative risk-taking essential to good corporate leadership. It is in eroding this critical element of management that high leverage probably has its most insidious effect."
The study's findings derive from an analysis of the relationship between the amount of debt involved in 3,024 corporate acquisitions between 1972 and 2003 and the response of Wall St. to those acquisitions. Abnormal market returns (that is, the performance of an acquirer's stock compared to the performance of the market as a whole) are analyzed for three periods -- 1) the five days comprising the announcement day and the two previous and two subsequent trading days; 2) an intermediate period starting with the third day following the announcement and concluding with the delisting of the target firm; and 3) a post-acquisition period comprising the 24 months following the target's delisting. The analysis controls for a whole variety of factors that can affect the market's response, including whether payment is in stock or cash; whether the target resists the acquisition; the relative size of the two firms; their cash holdings; and whether the target and acquirer are in the same industry.
Harrison and Oler find Wall St.'s initial response to high leverage to be mainly positive: the higher the acquirer's pre-acquisition debt and the higher the anticipated increase in debt that the acquisition will require, the more positive is the market's response. This trend is tempered, however, by an inverse relationship between the acquirer's stock returns in the announcement period and the level of the target's debt. As the authors put it, "The market partially recognizes the bad news of high target leverage around the announcement date."
The market's response to leverage does not change significantly during the intermediate period, but during the two years following merger it alters dramatically and becomes strongly negative. To illustrate, the authors calculate that shorting high-leverage acquirers on the day following target delisting and maintaining that position for two years will produce a return of 13% in excess of market yield over that time.
The authors acknowledge that other research has revealed high indebtedness to be salubrious in leveraged buyouts, in which private investors buy out current shareholders by issuing large amounts of debt. But "the performance improvements of LBOs are attributed to improvements in organizational structure, and not to increased leverage," they write. "These include adding new restrictive debt covenants, increasing the equity ownership of managers, and increasing the salaries of top managers to compensate them for increased risk...Without these compensating controls, we suspect that the outcomes of LBOs would be similar to what we report here."
Why, finally, does it take the reputedly efficient stock market so long to get it right on leverage in acquisitions? Basically, because big mergers are too complex, with too many novel elements, for the market to be able to gauge their outcome from the start with any consistency. As Harrison and Oler put it, "Acquisitions, because they are such complex events, may be particularly susceptible to errors in interpreting the full economic impact at the time of announcement."
The study, entitled "The Influence of Debt on Acquisition Performance," will be among several thousand research reports at the Academy of Management meeting. Founded in 1936, the Academy is the largest organization in the world devoted to management research and teaching. It has more than 18,000 members in 92 countries, including more than 10,000 in the United States. This year's annual meeting will draw more than 9,000 scholars and practitioners to Anaheim, California from August 10th to 13th for sessions on a host of subjects relating to business strategy, corporate organization and investment, the workplace, technology development, and other management-related topics
Media Coverage: Deals and the dark side of debt. (Thursday, August 14, 2008).
The New York Times. The dark side of deal debt. (Friday, August 15, 2008).

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