Financing and Performance: The Perils of Cash and Stock Payments

Acquisitions can be financed in a number of ways. The most common approaches, however, are the simplest: to pay with cash, and to pay with stock. Both have their pros and cons.
Research has shown, for example, that cash financed deals tend to under perform. Why? Two reasons have been put forward by the academic community. First — and from a behavioural perspective — Professor Michael Jensen, from Harvard Business School, showed in 1986 that cash financed deals tend to under perform, because cash-rich managers are more likely to make quick strategic decisions, and are more likely to engage in large-scale strategic actions, with less analysis, than their cash-strapped peers. High levels of liquidity, he suggested, increased managerial discretion, and make it possible for managers to pursue self-serving acquisitions, or to choose poor acquisitions when they run out of good ones. In other words, Jensen suggests that its not that cash, as a method of payment, leads to poor performance, but rather that cash predicts poor performance because the fact that cash-rich firms tend to make poorer acquisition decisions. 
Financial scholars come to the same conclusions, but in a different way. They suggests that cash, provides the firm with flexibility, and allows it to respond to both internal and external pressures for change. At the highest level, financial slack has been found to positively affect firm performance in general (Cheng and Kesner, 1997; Greenley and Oktemgil, 1998), and holding cash has been shown to positively impact merger performance in particular (Bruner, 1988; Wan and Yin, 2009). Acquisitions are complex, and risky events, and are often, despite the best of intentions, a ‘quest into the unknown’ (Teece, 1996). Having cash provides what Cyert and March (1963) term a ‘cushion of liquidity’, to protect the firm from unanticipated costs (Wan and Yin, 2009). A number of scholars have shown that firms without financial slack have difficulties in integrating their acquisitions (Hall, 1990, 1994; Hoskisson and Hitt, 1994; Hitt et al., 1996; Desyllas and Hughes, 2010), and as a result scholars have concluded that excess liquidity may be a necessary condition for firms looking to safely experiment in mergers and acquisitons (Majumdar and Venkataraman, 1993; Moses, 1992). Again, therefore, its not that cash, as a method of payment leads to poor performance, but rather that spending cash rather than keeping it in reserve for the integration process predicts poor performance. 
So using cash to finance a deal may be ill-advised. But what about stock then? The accepted wisdom is that acquirers should pay with stock when the firm is overvalued. Shleifer and Vishny (2003), writing in the Journal of Financial Economics, claim that overvalued firms can increase shareholder wealth by using their stock as currency to purchase less overvalued firms. This reasoning explains why merger announcements are related to stock price movements; a number of top studies (see for example, Rhodes-Kropf, Robinson, and Viswanathan, 2005; Dong, Hirshleifer, Richardson, and Teoh, 2006; and Ang and Cheng, 2006) show that the level of equity overvaluation increases a firm’s probability of becoming a bidder, and of using stock as the method of payment. And, conceptually, it makes sense: the overvaluation of the firms stock is temporary, and therefore using overvalued stock allows the firm to acquire real assets at a discount. 
Recent research, however, prepared by Fu, Lin and Officer, and published in the Journal of Financial Economics, questions this reasoning, and asks if acquisitions paid by overvalued stock make for good deals, and good performance (Fu et al., 2013). Using a sample 1,319 stock-financed, and 671 cash-financed acquisitions in the period 1985-2006, Fu et al (2013) show that overvalued acquirers often significantly overpay for the targets they purchase. They show that acquisitions paid for with the use of stock tend to under perform, but perhaps more importantly, and in comparing the long-run operating and stock price performance of the overvalued acquirers against that of similarly overvalued industry peers, the authors suggests that shareholders of overvalued acquirers would actually benefit if their firms had not pursued the acquisition. In doing so, Fu et al (2013) casts serious doubt on the wisdom is that acquirers should pay with stock when the firm is overvalued. And in this, Fu et al (2013) are not alone. Song (2007), Gu and Lev (2011), and Akbulut (2013) also conclude that such deals initiated by overvalued acquirers rarely create value. 
So where does this lead us? Clearly, to make an acquisition the firm must pay, and in choosing how the pay the firm has a limited number of options. The conclusion therefore isn’ that the acquirer shouldn’t pay with cash, or shouldn’t pay with stock, but rather that the acquirer should be aware that the choice of paying with cash and paying with stock isn’t always as straight forward as it might appear. In choosing to pay with cash, the manager may send the wrong signals to the market, and may put himself in a position of not having the resources necessary to properly integrate the target. In paying with stock, and in following the conventional wisdom on when to pay with stock, the evidence is that the results may be more disappointing. 
As always with mergers and acquisitions, the reality of the payment decision is more complex that it might have first appeared. 
About the Author
Dr. Killian McCarthy is assistant professor bij de University of Groningen. Hij behaalde zijn PhD in economics of corporate strategy in 2011, voor zijn onderzoek over overnameprestaties. In dit onderzoek evalueerde Killian de prestatie van 35,000+ deals in Europe, Noord-Amerika en Azië in de periode 1990-2010. 
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