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Cosmetic Mergers: The Effect of Style Investing on the Market for Corporate Control

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Cosmetic Mergers: The Effect of Style Investing on the Market for Corporate Control Massimo Massa* and Lei Zhang* Abstract We study the impact of style investing on the market for corporate control. We argue that a firm may choose to boost its market value by merging with a firm that belongs to a style that is more “less neglected” by the market. By using data on the flows in mutual funds, we construct a measure of neglectedness that is not a direct transformation of stock market data, but directly relies on the identification of the sentiment induced investor demand. We show that bidders tend to pair with targets that are relatively less neglected. The merge with a less neglected target generates a “halo effect” from the target to the bidder that induces the market to evaluate the assets of the more neglected bidder at the (inflated) market value of the less neglected target. Both bidder and target premia are positively related to the difference in neglectedness between bidder and target. The target’s ability to appropriate the gain is however reduced by the fact that its bargaining position is weaker when the potential for asset appreciation of the bidder is higher. The effect on the value of the bidder is persistent in the medium run (1-2 years). We document a better medium term performance of more neglected firms taking over less neglected ones. The bidder managers engaging in these types of “cosmetic mergers” take advantage of the temporary window of opportunity created by the higher stock price induced by the M&A deal to reduce their stake in the firm at convenient conditions. JEL Classification: G34; G23; G32 Keywords: mergers and acquisitions; style investing; short-termism; mutual funds; dumb money. *Finance Department, INSEAD. Please address all correspondence to Massimo Massa, INSEAD, Boulevard de Constance, 77300 Fontainebleau, FRANCE, Tel: +33160724481, Fax: +33160724045 Email: [email protected] We thank for helpful comments: Y.Amihud, M.Baker, J.Coval, R.Greenwood, L.Jin, A.Shleifer, J.Stein, J.Wurgler. All the errors are ours.1“Few if any of us have discussed with our students the consequences of a company’s stock price becoming overvalued. Indeed I know of nowhere in the finance literature where the problems associated with overvaluation are discussed. We talked for a long time in the 1980s about the effects of under-valuation, and I will have a little to say about that below. But as things have progressed over the last half-dozen years overvaluation has come increasingly to occupy my thoughts. Indeed, understanding the incentive and organizational effects of stock overvaluation will help us understand much about the current malaise in corporate finance and corporate governance that surrounds the events at Enron, WorldCom, Xerox, and many other companies.” (Jensen, 2004) Introduction In this paper, we study how the attitude of investors to allocate their assets according to “styles” affects the market for corporate control and generates a new rationale for mergers: the use of the merger as a way for a firm to cater to investors of different styles. A firm may choose to boost its market value by merging with another firm that belongs to a style that is more “favored” by the market. Let us consider an example. As investors are attracted by “new economy” firms, there will be less investor demand for “old economy” firms. What can an old economy firm do in order to increase its value? Increasing profitability would hardly help as the investors will keep discounting the increased cash flows with a higher discount rate. In fact, during the “.com frenzy”, negative cash flows were perceived as a positive signal. What a firm may do is to try to persuade the shareholders that it has become a “new economy” firm itself. That is, the firm has to demonstrate that it has acquired the very characteristics that attract the market to the new economy firms. This “cosmetic” process can be engineered by either changing the entire business plan of the firm or by simply merging with a firm that already has those characteristics. The latter option has the advantage of being fast.1 The merger produces a sort of “halo effect” that spreads from the less neglected target to the more neglected bidder. We will define the mergers used to change the firm’s investor appeal as “cosmetic mergers”. Neglected firms resort to them to boost their sagging price, while firms temporarily “favored” by the market use them to keep their price momentum. This rationale for mergers has not been considered in the literature. M&A activity has been explained in terms of industrial, financial or asset-based synergies. Alternatively, managerial overconfidence, hubris or the desire to time the market to exploit the temporary overvaluation of the bidder have been advocated. We consider the other cases, the situations in which firms take over firms that are more “in favor” with the markets in order to improve their own value. 1 The idea is similar to the case of firms changing names to appeal to new investors (Cooper, Dimitrov and Rau, (2005), Cooper, Gulen and Rau, (2005)).2No irrationality on the side of the managers is assumed and the M&A deal is the optimal reaction of (short-term) rational managers given the market conditions. The starting point is the fact that investors suffer from “coarse thinking” and “evaluate various proposition or objects using representativeness and categorization... Instead of having different models for different situations, individuals may be applying one generic model for all situations in the same category” (Mullanaithan and Shleifer, 2006). This implies that investors evaluate stocks on the basis of the styles they belong to — e.g., growth stock — as opposed to the fundamentals of the firms (e.g., Barberis and Shleifer, (2003), Teo and Woo (2001), Frazzini and Lamont (2005)). In doing this, investors affect stock market valuations as they privilege some styles at the expense of others. The stocks of firms belonging to styles that are not in favor with the investors will be neglected and will have depressed values. Firms in styles favored by the investors will see their quotations soar. Managers take notice of this style-based segmentation and, to boost their stock price, try to be perceived as part of a style that is in “favor” by merging with a favored firm. Indeed,


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