Leverage and Acquisition Performance (Digest Summary)

Although often thought of as a necessary currency in a company acquisition, debt in excessive amounts can negatively affect the performance of the acquiring company in the aftermath of the acquisition. The authors examine this dynamic in detail.

Leverage can often facilitate the acquisition process, but when used in excess, it may lead to imprudent business decisions and a focus on risk management at the expense of creating value for the shareholders. In the public markets, poor stock performance can be an indicator of excessive leverage in the wake of an acquisition. Initial positive market reaction to the announcement gives way to decreasing returns because company management may not properly anticipate the longer-term effects of leverage on stock price performance, particularly if the firm assumes additional debt. Noticeable changes in the company’s capital structure after an acquisition demand that debt service be the priority, which means that management has less flexibility at a time when it needs it.

The authors examine an extensive set of public acquisitions over a long time frame, subjecting the data to rigorous examination and analyses to account for possible biases and outlier events. These tests confirm their hypotheses and confirm the risks of outsized leverage. The leverage loses its role as a disciplinary tool. Instead, it stifles managerial performance because any excess cash flow goes toward debt repayment and is unavailable to be used to increase productivity and maximize shareholder value.

The implications of this research will be interesting to students and practitioners of corporate finance as well as to investors who could profit from what the authors call an “exploitable market anomaly.” Corporate boards that are evaluating potential acquisitions may also be interested in the results of this analysis.

The authors begin with a review of the literature on the use of debt to finance acquisitions. A traditional school of thought holds that leverage is prudent because of tax benefits for the borrower, and the debt service creates managerial discipline by limiting discretionary spending (the agency perspective). Conversely, excessive use of debt may not only focus on decision making but also limit management’s ability to pursue potentially profitable investment, which the authors call “risk balancing.” Debt service during an acquisition becomes important because leverage may increase over the course of an acquisition. The leverage typically comes from several sources—the acquirer, the target firm, and the need to satisfy expenses in the aftermath of the purchase.

The authors consider the interrelationship between the acquirer and the target, examining returns during the announcement, interim, and post-acquisition periods. The dataset includes 2,218 transactions in which both the acquiring and target firms are public companies included in the CRSP database and the acquirer purchased 100% of the target, which was subsequently delisted. The data are from 1972 to 2005. Utilities and financial firms are excluded because they are subject to additional regulation and are less comparable with other firms. Long-run returns are calculated by using a buy-and-hold approach. Acquirer and target leverage is the book value of current and long-term debt scaled by the book value of total assets. The authors control for target premium and size of the target firm, acquirer prior to the announcement date, and bankruptcy risk of both acquiring and acquired parties.

Parsing the data, the authors demonstrate that returns during the period of the acquisition announcement are positively correlated with both acquirer leverage and additional leverage. Post-acquisition returns decrease over time with added leverage. Leverage from additional borrowing or from the target firm may cause unanticipated problems for management. Eventual decreasing returns from an excess of leverage moderate initial market overreaction during the announcement period. The authors use numerous robustness checks to corroborate their results, such as controlling for outliers in post-acquisition returns.

The acquisition process is risky, and the use of credit to facilitate the process is one of the risks. Debt management comes at the expense of value creation, which is usually the intent of the acquisition in the first place. The authors’ research, which is extensive and robust in additional tests, builds on earlier literature that considers multiple points of view on the use of debt to finance acquisitions, including the one that warns that too much credit constrains managerial discretion in the post-acquisition management process. An interesting extension would be an investigation of both privately held targets and partial acquisitions. A sufficient amount of data would be necessary to make such research feasible.