With growth as a target, many companies look towards acquisitions as a method to expand their current business. The question of how to finance such purchases arises with many different options such as cash-for-stock, stock for stock or a combination of the two.
In Corporate Financing Decisions When Investors Take the Path of Least Resistance by Malcolm Baker, Joshua Coval and Jeremy C. Stein, the authors delve into the issue of financing acquisitions when taking into account investor behavior. Positing that many investors are “asleep,” or do not react to stock-for-stock financing, Baker et. al argues that companies should hold more merger stock-swaps as a method for raising equity than seasoned equity offerings. While investors of the target company would not have bought the acquiring company’s stock actively through the market, when the stock-for-stock buyout occurs, a fraction of the target company investors do not investigate the buyout and continue to hold the acquiring firm’s stock. This investor “inertia” occurs at a much higher rate with individual investors than institutional holders, who are much more likely to see the acquiring firms. However, both types of investors do exhibit investor inertia enough that this behavior contradicts the theory that all investors are actively participating in the market and responding according to all new and relevant information. Allowing for this behavior change, the acquiring company needs to consider its buyout options differently.
Baker et. al uses data from 3,003 successful transactions over 15 years to solidify the investor inertia hypothesis. Drawing on turnover of ownership of target stock data during the merger and during a normal period, the authors show that upwards of 80% of individual investors are asleep, retaining the acquiring company’s stock after a stock swap. Employing the same information for institutional holders, the authors find that only around 30% of intuitions are “asleep”. In addition, the authors investigate the possibility of capital gains tax or the size of the merger having an effect on the target shareholders’ decision-making. For capital gains tax consideration, institutions show none and individuals have a modest change. For the size of the merger, individuals show no change in behavior, while institutions are slightly more active with a big target.
Looking further at the implications of the individual investor inertia for holding stock, Baker et. al explore the impact on the price of the acquiring firm. A target company’s ownership structure that includes a high percentage of individuals and fewer institutions will have more investor inertia and retention of the acquiring company’s stock. Given the assumption of a downward sloping demand-curve due to differences in investor’s information and thus opinions, fewer of the acquiring company’s stock reaching the open market will lessen the negative impact of an equity offering. In the reverse, the more institutional holders existing in the target company, the pricing pressure on the acquiring firm will be much more.
The truly interesting part of these results is the changes in financing behavior companies should use. While some companies might have a specific preference towards one type of financing, the conclusion of the investor inertia distinguishes the stock-swap in mergers as a better way to raise equity than a seasoned equity offering. Using stock-for-stock financing is more profitable for fast, equity-based growth.
After reading this paper, I was pleased with the content and writing style. I found the topic interesting and thoroughly explained. The data helped to support the authors claims. The only question I had was about the selection of the data set. The variety of successful mergers over 15 years must be plentiful. However, Baker et. al offer no explanation of how they selected the 3,003 transactions they used. While the paper convinced me of the existence of investor inertia, there is a possibility that data set had been hand selected to show investor inertia. Besides this minor point, the investor inertia makes sense to be not only because of the data, but also because of the simply reasoning of investor behavior.