Investors are slow

Baker, Coval, and Stein argue that the behavior of investors of a firm about to be acquired during a merger can be predicted and used to the benefit of the purchasing firm to develop the optimal capital structure for the ensuing acquisition. Investors exhibit inertia: when investors in firm A are bought out by firm B using stock from firm B (i.e. a stock-for-stock merger), the investors will keep this new stock in firm B. The significance of this holding of firm B stock is that these shares never reach the market, and, therefore, in the face of a downward sloping demand curve, are valued at a price above their market one. This research finds that 78% of individual investors and 32% of institutional investors exhibit inertia. Therefore, in order to optimize the merger, the acquiring firm must consider the composition of target firm’s investors: the greater the inertia, the greater the benefit of using stock-for-stock purchases. However, the overuse of stock swap will over-saturate the market with the acquiring firm’s shares (price pressure) and devalue its price.

Central to understanding how investor inertia can be used by the acquiring firm to purchase the target firm at a cheaper price (i.e. with less shares of the acquiring firm’s stocks) is the idea that under normal stock market conditions, the stock prices lie on a downward sloping demand curve. Classic stock market theory states that because the market efficiently prices stocks and everyone is a price-taker that the demand curve is horizontal. If this was the case during a merger, inertia would be irrelevant. This paper argues, however, that a downward-slope arises “not from asymmetric information, but rather from irreducible differences of opinion among investors as to the value of [the acquiring firm’s] pre-existing assets.” Therefore, when the acquiring firm gives more shares publicly to the target firm investors in order to purchase the target, this increase in shares in an open market pushes the price down the demand curve, lowering the stock price. The decrease in open market price is logical because investors in the target firm previously preferred the target firm and the increase in the acquiring firm’s stocks publicly available creates a price pressure. Therefore, if dumped to the open market, these shares from the acquiring firm would fetch a lower price. However, because these shares never reach the market, they remain at a higher price, which is of course beneficial to the acquiring firm.

Investor inertia is derived from three sources:

1. endowment effects
2. the tendency of investors to procrastinate before making decisions
3. the costs inherent with evaluating and optimizing their new portfolio.

This paper tests inertia empirically by studying roughly 3000 mergers, 2000 of which were completed with stock-swap deals. These 1000 other deals serve as different controls. Inertia was defined as “the fraction of target-only investors doing nothing” after a merger and factoring for variables such as normal stock turnover. It was determined that 32% of individuals and 78% of institutions exhibit inertia. Essentially, the institutions do a better job monitoring changes and reacting more quickly than individuals. Corresponding to less inertia, institutions also had a much higher trading volume around the merger.

This paper also examines possible reasons for the dichotomy between institutional and individual investors and finds the difference to be behavioral rather than inherent. For example, the greater propensity for individual inertia could be mistaken for the fact that individuals do not sell the new shares because they do not want to incur capital gains taxes, which nonprofit institutions legally avoid. However, they argue that rational individual investors will be aware of the tax ex ante, and because they are forced to hold stock that they do not value highly, individuals will demand a greater number of shares as compensation prior to the merger. This means, in effect, that the acquirer would bear the costs of the tax friction of the shares inefficiently placed “in the wrong hands.” In comparison, if the target shareholders are non-taxable, then the shares will reach the hands of the “previously-sidelined A-investors who value them more highly.” This example illustrates well why investor inertia works to the advantage of the acquiring firm: unlike ex ante considerations such as capital gains tax or even price drop, these investors who find themselves with shares of the acquiring firm due to the merger do not need to be compensated for these inefficiencies.

Acquiring firms, therefore, can use inertia in stock-swaps to effectively lower the cost of their takeover. This option has its pitfalls though. It is important that the acquiring firm assesses the inertia of their new investors. Less inertia which is characteristic of institutional ownership coupled with acquiring firms with steeply-sloped demand curves can lead to more selling pressure and a negative announcement effect. The data supports that acquiring firms are aware of this on some level: empirical evidence shows a negative relationship between target institutional ownership and the probability that a merger is conducted with stock.