European Financial Management, VOL 10:1 March 2004

Shareholder Wealth Effects of European Domestic and Cross-border Takeover Bids

Marc Goergen and Luc Renneboog

Abstract
This paper analyses the short-term wealth effects of large intra-European takeover bids. We find announcement effects of 9% for the target firms compared to a statistically significant announcement effect of only 0.7% for the bidders. The type of takeover bid has a large impact on the short-term wealth effects with hostile takeovers triggering substantially larger price reactions than friendly operations. When a UK firm is involved, the abnormal returns are higher than those of bids involving both a Continental European target and bidder. There is strong evidence that the means of payment in an offer has an impact on the share price. A high market-to-book ratio of the target leads to a higher bid premium, but triggers a negative price reaction for the bidding firm. We also investigate whether the predominant reason for takeovers is synergies, agency problems or managerial hubris. Our results suggest that synergies are the prime motivation for bids and that targets and bidders share the wealth gains.

Keywords: Mergers and acquisitions, domestic and cross-border takeover bids, hostile takeovers, the market for corporate control, short-term wealth effects.

JEL Classification: G32, G34

Abstract
This paper looks at the value generated to shareholders by the announcement of mergers and acquisitions involving firms in the European Union over the period 1998-2000. Cumulative abnormal shareholder returns due to the announcement of a merger reflect a revision of the expected value resulting from future synergies or wealth redistribution among stakeholders. Target firm shareholders receive on average a statistically significant cumulative abnormal return of 9% in a one-month window centred on the announcement date. Acquirers’ cumulative abnormal returns are null on average. When distinguishing in terms of the geographical and sectoral dimensions of the merger deals, our main finding is that mergers in industries that had previously been under government control or that are still heavily regulated generate lower value than M&A announcements in unregulated industries. This low value creation in regulated industries becomes significantly negative when the merger involves two firms from different countries and is primarily due to the lower positive return that shareholders of the target firm enjoy upon the announcement of the merger. This evidence is consistent with the existence of obstacles (such as cultural, legal, or transaction barriers) to the successful conclusion of this type of transaction, which lessen the probability of the merger actually being completed as announced and, therefore, reduce its expected value.

Keywords: mergers and acquisitions, Europe, event study.

JEL Classification: G34, G38, L44

Abstract
We analyze the abnormal returns to target shareholders in cross-border and domestic acquisitions of UK companies. The cross-border effect during the bid month is small (0.84 percentage points), although cross-border targets gain significantly more than domestic targets during the months surrounding the bid. We find no evidence for the level of abnormal returns in cross-border acquisitions to be associated with market access or exchange rate effects, and only limited support for an international diversification effect. However, the cross-border effect appears to be associated with significant payment effects, and there is no significant residual cross-border effect once various bid characteristics are controlled for.

Keywords: Mergers and acquisitions; shareholder returns; cross-border; differential wealth effects

JEL Classification: G34, G14, G15

Abstract
We study 98 large M&As of European bidding banks from 1985 to 2000 in order to investigate drivers of excess returns to the shareholders of the targets, the bidders, and to the combined entity of the bidder and the target. Our findings show that many of 13 drivers identified mostly from prior, US-focused research have significant explanatory power, indicating that the stock market reaction to M&A-announcements of European bidding banks can be at least partly forecasted. Our results are largely consistent with the US-experience and confirm the preference of stock markets for focused transactions and against diversification. Moreover, we find that less active bidders create more value than more active/experienced bidders. This stands in contrast to some US research and may indicate that managers of frequent European bidding banks may be motivated by other objectives than creating shareholder value.

JEL Classification: G14, G21, G34

Keywords: European banks; bank mergers; mergers and acquisitions; shareholder value

Abstract
This paper investigates the effects of takeovers on workers’ employment prospects and wages in the United Kingdom for the years 1987-1995. We address directly the idea that takeovers involve a "breach of trust" with employees. Our results provide no support for the breach of trust hypothesis and rather suggest shareholders and workers in the post-acquisition joint entity are locked in a form of ``equal misery`` following the execution of the takeover.
There already an exist a wide range of event studies documenting the effect of takeovers on shareholders and a smaller number of studies discussing the impact of takeovers on employees. The contribution of the present study is to relate the separate effects of acquisition on these two groups to each other. By doing so we seek to test directly the proposition that takeovers reallocate rents from workers to target shareholders, via the bid-premia paid on acquisition.

Keywords: Restructuring, job loss, trust, wealth transfers

JEL Classification: G3, G18, L14

Abstract
This study investigates the determinants of changes in corporate ownership and firm failure for German firms. We find that many of the determinants of failure also affect ownership changes in this bank-based economy. They include poor performance, weak corporate governance, high leverage, and small firm size. The ownership structure also plays a role for both events. Separate analyses of one of these events are therefore likely to miss important effects. The implications for the German corporate governance system are that the differences to countries with more market-based systems are not as pronounced as previously speculated.

Keywords: Bankruptcy, corporate governance, ownership structure

JEL Classification: G32, G33, G34

European Financial Management, VOL 10:2 June 2004

Why Study Large Projects? An Introduction to Research on Project Finance

Benjamin Esty

Abstract
Despite the fact that more than $200 billion of capital investment was financed through project companies in 2001, an amount that grew at a compound annual rate of almost 20% during the 1990s, there has been very little academic research on project finance. The purpose of this article is to explain why project finance in general and why large projects in particular merit separate academic research and instruction. In short, there are significant opportunities to study the relationship among structural attributes (i.e., high leverage, contractual details, and concentrated equity ownership), managerial incentives, and asset values, as well as improve current practice in this rapidly growing field of finance.

Abstract
We argue that when individuals care about their consumption relative to that of their neighbors, a home bias emerges, that is investors overweight domestic stocks in their portfolios. Domestic stocks are preferred because they also serve the objective of mimicking the economic fortunes and welfare of the investor’s neighbors, countrymen, and social reference group. We also demonstrate that globalization mitigates the home bias, and derive a modified International CAPM.

Keywords: International diversification; Home bias; Relative preferences; International CAPM.

JEL Classification: F30, G11, G12, G15

Abstract
In this paper we examine the proposition that small investor sentiment, measured by the change in the discount/premium on closed-end funds, is an important factor in stock returns. We conduct an out-of-sample test of the investor sentiment hypothesis in a market environment that is more likely to be prone to investor sentiment than the U.S.. We fail to provide supporting evidence of the claim of Lee, Shleifer, and Thaler (1991) that investor sentiment affects the risk of common stocks. Consistent with Elton, Gruber, and Busse (1998), who show that investor sentiment does not enter the return generating process, our tests do not detect investor sentiment in a capital market that is more susceptible to small investor sentiment. Our results provide additional support against the claim that investor sentiment represents an independent and systematic asset pricing risk.

Keywords: Closed-end-funds; discounts/premiums; investor sentiment; stock returns.

JEL Classification: G12, G14

Abstract
Recent empirical work shows evidence of higher valuation of firms in countries with a better legal environment. We investigate whether differences in the quality of firm-level corporate governance also help to explain firm performance in a cross-section of companies within a single jurisdiction. Constructing a broad cor-porate governance rating (CGR) for German public firms, we document a positive relationship between governance practices and firm valuation. There is also evi-dence that expected stock returns are negatively correlated with firm-level corpo-rate governance, if dividend yields are used as proxies for the cost of capital. An investment strategy that bought high-CGR firms and shorted low-CGR firms earned abnormal returns of around 12 percent on an annual basis during the sample period.

JEL Classification: G12, G34, G38

Abstract
This paper investigates the determinants of corporate cash holdings in EMU countries. Our results suggest that cash holdings are positively affected by the investment opportunity set and cash flows and negatively affected by asset’s liquidity, leverage and size. Bank debt and cash holdings are negatively related, which supports that a close relationship with banks allows the firm to hold less cash for precautionary reasons. Firms in countries with superior investor protection and concentrated ownership hold less cash, supporting the role of managerial discretion agency costs in explaining cash levels. Capital markets development has a negative impact on cash levels, contrary to the agency view.

Keywords: Cash holdings; Liquidity; Agency costs; Corporate Governance.

JEL Classification: G3, G32, G39

Abstract
This paper uses implied volatilities from foreign exchange option prices and the results of no-arbitrage theory to estimate foreign exchange risk premia. In particular, under the assumption of no-arbitrage, the foreign exchange risk premium is driven by the difference between investors’ market prices of risk in the two currencies. In an international economy with three currencies, sterling, US dollar and Deutschemark, we can use the information on implied volatilities of the three cross rates to derive estimates of implied or ex ante market prices of risk and of foreign exchange risk premia. The foreign exchange risk premia estimates are then compared to survey-based risk premia.

Keywords: foreign exchange; risk premia; pricing kernel.

JEL Classification: G12, G15, F31

Abstract
We survey European managers to gain some insights into motivations of convertible issuance. Our analysis shows that a majority of firms issue convertibles as “delayed equity” and as “debt sweetener”. Managers also use convertibles to avoid short-term equity dilution and to signal firm’s future growth opportunities. We document a large cross-sectional variation across firms in rationales for issuing convertibles and find mixed support for most theoretical models. Our evidence suggests that the popularity of convertibles is driven primarily by their versatility in adjusting their design to fit the financing needs of individual firms, and by their increased demand among institutional investors.

Keywords: Convertible Debt, European Managers, Survey, Delayed Equity, Debt Sweetener

JEL Classification: G32, G15, F23

European Financial Management, VOL 10:3 September 2004

Divergence of US and Local Returns in the After-Market for Equity Issuing ADRs

Padma Kadiyala and Avanidhar Subrahmanyam

Abstract
We study one-year post-listing prices and returns to equity issuing ADRs that listed in the US between January 1991 and October 2000. ADRs from countries that impose restrictions on capital flows are priced at a premium to their home market ordinaries. While the mean premium for the full sample is statistically indistinguishable from zero, after an adjustment for asynchronous trading, the magnitude of the premium to ADRs from restricted markets is 11.33% at the 300-day post listing interval, which is statistically significant. In the short run (30 days) following listing, the magnitude of the premium is larger for ADRs with larger excess demand from US investors. At the longer 300-day horizon, Nasdaq listed ADRs earn a larger premium than their NYSE/AMEX listed counterparts. Time-series regressions and two-stage cross-sectional regressions establish that the premium to foreign equity issuers is greater if the US listing attracts liquidity and if US returns have a lower correlation with the local country index.

Keywords: ADRs, Market Efficiency, International Finance

JEL Classification: F30, G12, G14

An empirical analysis of Finnish mutual fund expenses and returns

Timo Korkeamaki and Thomas Smythe, Jr.

Abstract
A tremendous amount of research examines U.S. mutual funds, but fund markets also thrive in other countries. However, research about these fast growing markets is lacking. This study addresses Finnish funds. Fast growth of the Finnish fund industry, strong bank dominance in the industry, and recent EU membership make it an interesting market to examine. The Finnish fund market is also of particular interest since it had the fastest growth among the EU countries during 1996-2000. We find evidence that bank-managed and older funds charge higher expenses but investors are not compensated for paying higher expenses with higher risk-adjusted returns, suggesting a potential agency problem. Overall, Finnish fund expenses have decreased over time, consistent with EU membership reducing market segmentation and generating competition.

Keywords: Mutual funds, fees, returns, international.

JEL Classification: G15, G18, G20

Multinational Diversification and Corporate Performance: Evidence From European Firms

Ike Mathur, Manohar Singh and Kimberly C. Gleason

Abstract
We investigate the empirical relationship between accounting based measures of performance and the degree of multinational diversification for a set of European chemical industry firms. We find that for these firms, the degree of multinational diversification is strongly related to superior financial performance. The results hold for each of the three sample years. The findings suggest that multinational firms outperform purely domestic and exporting firms. The results provide strong support for gains from multinational diversification. The results indicate that while greater European unification may have eroded potential benefits of exploiting international capital and product market imperfections, the benefits of firm specific economies of scope and scale as well as managerial and financial synergies are still realized through exports.

Keywords: Multinational diversification; corporate performance; European unification

JEL Classification: F23, F21, F31

The Cost of Capital of Cross-listed Firms

Koedijk Kees and Van Dijk

Abstract
This paper analyzes the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross-listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1983) and Sercu (1980) including both the global market portfolio and exchange rate risk premia, and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross-listed stocks from nine countries in the period 1980-1999. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12 percent of the cross-listed companies. The size of the cost of capital differential is around 50 basis points for the U.S., 80 basis points for the U.K., and 100 basis points for France.

Keywords: Cross-listings, cost of equity capital, foreign exchange exposure

JEL Classification: G15, G31, F31

The Effects of Monetary Unification on German Bond Markets

Hans Dewachter, Marco Lyrio and Konstantijn Maes

Abstract
We develop a benchmark against which the effects of ECB monetary policy on the German bond market can be evaluated. We first estimate an affine term structure model for the pre-EMU period linking the German yield curve with the Bundesbank monetary policy. The German monetary policy and its implied yield curve are then reprojected onto the EMU period. The reprojected yield curve differs significantly from the observed one. Short-term interest rates during the EMU period are significantly lower than they would have been in case the Bundesbank were still in charge of monetary policy. Furthermore, yield spreads increased substantially during the EMU period.

Keywords: EMU, ECB, Bundesbank, central bank monetary policy rule, essentially affine term structure model

JEL Classification: E43, E44, E52, E58

Exchange Rates and Capital Flows

Robin Brooks, Hali Edison, Manmohan S. Kumar, Torsten Sloka

Abstract
This paper explores the ability of portfolio and foreign direct investment flows to track movements in the euro and the yen against the dollar. Net portfolio flows from the euro area into U.S. stocks possibly reflecting differences in expected productivity growth track movements in the euro against the dollar closely. Net FDI flows, which capture the recent burst in cross-border M&A activity, appear less important in tracking movements in the euro-dollar rate, possibly because many M&A transactions consist of share swaps. Movements in the yen versus the dollar remain more closely tied to conventional variables such as the current account and interest differential.

Keywords: Exchange rate models, euro/dollar and yen/dollar exchange rates, capital flows

JEL Classification: F31, F32

European Financial Management, VOL 10:4 December 2004

The Agency Costs of Overvalued Equity and the Current State of Corporate Finance

Michael C. Jensen

Keywords: Overpriced Equity; market mistakes; misvaluation; failure of corporate governance; control; incentives; Investment banks; security analysts; naive investors.

Analyzing Perceived Downside Risk: the Component Value-at-Risk Framework

Winfried G. Hallerbach and Albert J. Menkveld

Abstract
Multinational companies face increasing risks arising from external risk factors, e.g. exchange rates, interest rates and commodity prices, which they have learned to hedge using derivatives. However, despite increasing disclosure requirements, a firm’s net risk profile may not be transparent to shareholders. We develop the ‘Component Value-at-Risk (VaR)’ framework for companies to identify the multi-dimensional downside risk profile as perceived by shareholders. This framework allows for decomposing downside risk into components that are attributable to each of the underlying risk factors. The firm can compare this perceived VaR, including its composition and dynamics, to an internal VaR based on net exposures as it known to the company. Any differences may lead to surprises at times of earnings announcements and thus constitute a litigation threat to the firm. It may reduce this information asymmetry through targeted communication efforts.

Keywords: Value-at-Risk, factor models, risk decomposition

JEL Classification: G3, G32, G1, G14

The Comovement of US and UK Stock Markets

Tom Engsted and Carsten Tanggaard

Abstract
US and UK stock returns are highly positively correlated over the period 1918-1999. Using VAR-based variance decompositions, we investigate the nature of this comovement. Excess return innovations are decomposed into news about future dividends, real interest rates, and excess returns. We find that the latter news component is the most important in explaining stock return volatility in both the US and the UK and that stock return news is highly correlated across countries. This is evidence against Beltratti and Shiller's (1993) finding that the comovement of US and UK stock markets can be explained in terms of a simple present value model. We interpret the comovement as indicating that equity premia in the two countries are hit by common real shocks.

Keywords: Comovement of stock returns; Variance decomposition; VAR model; Bias-correction; Bootstrap simulation.

JEL Classification: C32, G12

How Fundamental are Fundamental Values? Valuation Methods and Their Impact on the Performance of German Venture Capitalists

Ingolf Dittmann, Ernst Maug and Johannes Kemper

Abstract
This paper studies how the use of alternative valuation methodologies affects investment performance for a sample of 53 German venture capitalists. We measure investment performance by the amount of investments they need to write off and by the number of companies they take public. We find that a significant number of investment managers use discounted cash flow (DCF) techniques, but only a minority appears to use a discount rate related to the cost of capital. The majority applies DCF using subjective discount rates. We present evidence that the use of DCF is correlated with superior investment performance only if applied in conjunction with an objectifiable discount rate. Also, funds that invest with a longer horizon perform better. The use of multiples is not significantly correlated with investment performance. We conclude that a focus on fundamental values confers an advantage.

Keywords: DCF, Performance, Valuation, Venture Capital, IPO

JEL Classification: G15, G24, G31

PROFESSIONAL FORUM

Political Uncertainty, Financial Crisis, and Market Volatility

Jianping Mei and Limin Guo

Abstract
This paper examines the impact of political uncertainty on financial crises using a panel of twenty-two emerging markets. By examining political election cycles, we find that eight out of nine of the financial crises happened during the periods of political election and transition. Using a combination of probit and switching regression analysis, we find that there is a significant relationship between political election and financial crisis after controlling for differences in economic and financial conditions. We observe increased market volatility during political election and transition periods. Our results suggest that political uncertainty could be a major contributing factor to financial crisis. Thus, politics does matter in emerging markets. Since the odds of financial crisis tend to be much larger during the political election periods, institutonal investors should take that into account when making emerging market investment during those time periods.

Keywords: Political Elections, Currency Devaluation, and Market Contagion