Evidence From Chinese Firms Conducting Mandas

Published Date: 02 Nov 2017

By

Arun Paragh

Student number: 321388

Master Thesis Proposal

Supervisor:

Dr. Hao Jiang

Co-reader:

Abstract

CONTENTS

INTRODUCTION

Finance literature is abundant with research on mergers and acquisitions (M&A), more so in western developed economies than in emerging markets. This is due to having a more mature stock market supported by a strong legal environment. Although recently M&A activity in emerging markets is becoming more common, as their respective stock markets become more developed and laws are better regulated and enforced. (SOURCE). In this respect, China is especially interesting for M&A research as the development is relatively stronger than other emerging markets. This thesis will analyse the benefits of mergers and acquisitions by US firms in China, during the crisis period of 2008-2010. The research question is as follows:

Research question

Did the M&A announcements of Chinese firms investing in American companies generate abnormal returns during the 2008-2010 crisis period?

Motivation of its relevance/importance by using facts and findings

Research on M&A in China has only recently been undertaken and as of yet the effects of the financial crisis of 2008-2010 on M&A in china is still unclear. This thesis will attempt to shed light on the subject and provide insight into the degree of development of Chinese stock markets. According to La Porta et al. (1999) many developing economies such as China suffer from a weak legal environment as well as enforcement of legislation. As such it is interesting to analyse to what degree M&A activity in China differs to that of the more western developed economies. This has not been extensively analysed as of yet mainly due to the lack of comprehensive databases on M&A transactions in emerging markets and relatively small economies of scale and scope in these markets (Ma et al. 2009).

Formulate problem statement and research question(s)

Hypothesis 1: M&A announcements of the acquiring firm generate positive abnormal returns.

Hypothesis 2: There is evidence of information leakage prior to M&A announcements.

Hypothesis 3: M&As that will be cash-funded show higher abnormal returns that when primarily equity-funded.

State your contribution to the literature

This thesis will contribute to current M&A literature by investigating the effects of the financial crisis on M&A activity in China. More specifically, I will analyse whether or not announcements of M&A activities in the aforementioned period generated abnormal returns. Also, the presence of information leakage will be analysed to discern the amount of insider trading and moreover the quality and upholding of legislation regarding such insider trades. Lastly I will analyse the impact the method of payment (cash versus equity) has on the M&A announcement.

With these points, my intention is to contribute to current M&A literature by analysing the effect the financial crisis had on M&A activity in China, where M&A research is quite new.

Indicate your research methodology

To analyse the abnormal returns generated as a result of M&A announcements, it is common practice to use event study methodology as formulated by Brown & Warned (1985).

Indicate your data and database(s)

I will use M&A announcements. The Erasmus Data Service Centre provides access to several financial databases such as the SDC (via ThomsonOne), Thomson One Banker (TOB) and ThomsonOne (T1).

LITERATURE REVIEW

Short overview of/introduction to this chapter

The effects of merger announcements on stock prices have been extensively analysed and discussed in finance literature. Although there has been more than thirty years of M&A research, opinions are still mixed. There is some common ground: the consensus seems to be that on average shareholders of the acquired firm experience positive abnormal returns and shareholders of the acquiring firm earn none or a slight negative return. (SOURCE)

This section will first discuss the methods used to measure M&A success and will then go on to explain the different schools of thought as to why firms commit to M&As when empirical research finds no significant value adding effect (‘the M&A success paradox Cording et al 2002). The last section will discuss recent research on M&A activity in China, specifically cross-border M&As by Chinese firms in the US.

Research methods for assessing M&A success

In the finance literature, four main methods have been used to analyse what the impact is of M&As on the firms involved. These four methods are: event-study methodology which looks at the stock price reaction during the M&A announcement, accounting measures which takes on a more long-term approach and primarily judges the M&A success by accounting ratios such as the return on equity, survey data which solicits opinions of the management whether the M&A was successful and lastly case studies which takes into account that each M&A case is specific and has idiosyncratic features which together warrant individual examination.

tFour principle methodologies have been employed: event study, accounting-based measures, survey data and case studies.

Event Study

The bulk of financial research into the value effects of M&A is done using event study methodology.

Traditionally, the capital asset pricing model (CAPM) has been the primary measurement tool for determining the degree to which mergers and acquisitions create economic value. Utilizing the "event study methodology" (Fama, 1968), the stock prices of both acquiring and acquired firms are examined shortly after the merger announcement. The "cumulative abnormal returns" are calculated (the increase in stock price over and above that which CAPM would predict absent the merger), and the results assessed. The central underlying assumption is that investors are capable of accurately predicting the combined firm’s future cash flows. The event study methodology has several attractive features. First, the data is publicly available, permitting empirical studies on large data samples. Second, it relies upon the well-respected efficient market hypothesis. Third, because "abnormal" returns are calculated, the data is not subject to industry sensitivity, enabling a broad cross-section of firms to be studied. These studies have provided support for the view that mergers and acquisitions create economic value (Jensen & Ruback, 1983; Seth, 1990b; Singh & Montgomery, 1987.) Later studies examined the distribution of this new wealth, and concluded that the stockholders of acquired firms capture most of the gains (Chatterjee, 1986; Datta, Pinches & Narayanan, 1992; Seth, 1990a; Singh & Montgomery, 1987; Sirower, 1997.) Indeed, the stock price performance of acquiring firms raises serious concerns: only about 35% of acquirers report positive stock market gains on the announcement date (for a useful review of these analyses, see Sirower, 1997.) These event study results, however, may be due to its reliance on the assumption that investors can accurately predict the combined firm’s future cash flows. This assumption embodies the attractive feature of ensuring that non-m&a related factors are not influencing the incremental stock behavior. Abandoning this assumption represents a direct challenge to the efficient market hypothesis (Shleifer & Vishny, 1991.)

Accounting-based measures

Over the past fifteen years, scholarly attention shifted to exploring different dependent variables. Perhaps the issue was not one with m&a "success", but rather with the event study methodology’s assumptions regarding success. Studies began using accounting-based measures of performance, market share data, and survey responses, and regressed these against various factors hypothesized to drive financial performance. The definition of "success" began to take on a longer-term perspective: perhaps it took three to five years to fully reap the benefits of the combined firm. Krishman, Miller and Judge (1997), for example, hypothesized that the ability of top management teams to work effectively together would drive m&a success, measured by return on assets. Ramaswamy (1997) explored the impact of strategic similarity in mergers occurring in the banking industry. Again, return on assets was used to measure performance over a three-year period. But accounting measures are subject to one of the same limitations as are long-term stock price measurements: factors other than the merger or acquisition may be driving the numbers. In addition, accounting measures reflect the past, rather than present financial performance expectations (Montgomery & Wilson, 1986.) Nor do they reflect changes in the firm’s risk profile. Some academics have opted to use survey measures to elicit the management team's views on whether or not the merger was a success (Cannella & Hambrick, 1993; Capron, 1999; Chatterjee, Lubatkin & Weber, 1992.) In theory, a merger or acquisition should be deemed a "success" if the objectives identified during the due diligence process are met. In other words, the key question may be, "Did we accomplish what we set out to accomplish, regardless of other exogenous or endogenous factors simultaneously at work?" Capron’s recent survey-based work claims: "…traditionally available financial data are too gross to permit differentiation between the types of fine-grained value-creating mechanisms…" (Capron, 1999: 993.) While these approaches rely on self-reported perceptions of long-term performance, they reduce some of the noise that may accompany publicly available information.

Case studies

Because every merger and acquisition is a unique event, occurring in a unique environment that is subject to innumerable influences, case studies have also provided a rich stream of research (Haspeslagh & Jemison, 1991; Marks & Mirvis, 1998; Shanley & Correa, 1992.) While it is not possible to generalize to other specific situations, the case study methodology does enable one to generalize to theoretical constructs. This analytic device enables the analysis of processes of value creation, rather than simply events seeking to create value. These results, combined with the observation of continued growth in merger and acquisition activity, gives rise to the "m&a success paradox." If we assume that managers are rational, and that corporate governance structures serve as a check and balance on poorly conceived strategic actions, we would expect the level of m&a activity to taper off, which has not been observed. To date, scholars have been unable to unravel the m&a success paradox.

Thus the exact rationale behind mergers and takeovers seems flawed, considering that most mergers destroy value (SOURCE). Although puzzling in itself, there are several theories attempting to explain this empirical phenomenon:

Factors influencing M&A outcomes: eight schools of thought

While the above empirical work focused on the average distribution of various performance measures, scholars have also sought to isolate those variables that may drive superior performance. The question then turns to what obstacles are faced in generating wealth for the acquiring firm’s shareholders; i.e., what variables management should manipulate to improve the odds of success? This section reviews eight schools of thought that emerge from the literature regarding the key issues that must be tackled to make a strategic acquisition work in terms of financial performance. These schools are: Overpayment; Agency Problems; CEO Hubris; Top Management Complementarity; Experience; Employee Distress; Conflicting Cultures; and, Process.

Overpayment (Premium) Hypothesis

Most researchers assume, either implicitly or explicitly, that acquisitions occur in a highly competitive market (i.e., the market for corporate control) and that prices are bid up to their "fair" value. Sirower (1997) presents a direct challenge to this assumption: "The first step in understanding the acquisition game is to admit that price may have nothing at all to do with value. I call this the synergy limitation view of acquisition performance. In this view, synergy has a low expected value and, thus, the level of the acquisition premium predicts the level of losses in acquisitions." (Sirower, 1997: 14, emphasis in original.) While the premium is known and paid up-front, the synergy gains are uncertain, derived in the future, and difficult to obtain. When calculating the net present value of these future synergies, a relatively high discount rate should be used, reflecting the risk of actually generating the synergistic effects. Pointing out the risks involved in paying a premium, Sirower (1997) urges executives to be clear about how synergy gains are to be extracted and the strategies for doing so. Some researchers warn executives to "walk away" if the price exceeds what they were originally prepared to pay (Haspeslagh & Jemison, 1991; Kusewitt, 1985.) Sirower (1997) argues that the presumption of outcomes should be failure. Others have pondered why managers may overpay for an acquisition. The process of identifying a suitable acquisition candidate and negotiating its price is riddled with problems. The analyses often occur in secrecy and under significant time constraints. Complete data is often not available. Haspeslagh and Jemison (1991) report that a majority of executives feel that a breakdown in the due diligence process led to a poor purchase decision. One aspect of the problem is the occurrence of "fragmented perspectives"; due to the complexity and speed required, it is difficult for any one person to develop a broad, but detailed, view of the acquisition opportunity (Jemison & Sitkin, 1986.) Given the bounded rationality (Cyert & March, 1963; Lubatkin, 1983), the opportunity to misjudge qualities in this due diligence environment is quite high. The building of momentum to complete the transaction further exacerbates this danger zone. Momentum builds in an unpredictable way, reflecting increased personal commitment on the part of the due diligence participants, the environment of secrecy and intensity, and the influence of outside advisors. (Haspeslagh & Jemison, 1991.)

Agency Problems Hypothesis

Researchers began to query the role of agents in the acquisition process, especially those involved in negotiating the transaction’s price. Kesner, Shapiro and Sharma (1994) investigated how investment bankers’ influence the size of the premium. Because compensation paid to these bankers is positively related to the purchase price, managers may harm the long-term health of their firms rather than securing the best possible value. (Kesner, et al, 1994.) Focusing on a possible agency problem between the interests of the chief executive officer and shareholders in mergers and acquisitions, several studies have found that CEO compensation increases with the size of the firm, regardless of firm performance. (Lubatkin, 1983, Schmidt & Fowler, 1990.) There thus seems to be an incentive for CEOs to increase firm size rather than firm profitability. Kroll, Wright, Toombs and Leavell (1997) investigated the nature of acquisition decisions from the perspective of corporate ownership and control. They categorized firms along three dimensions. Manager-controlled firms are those firms with diffused external shareholder ownership; no single shareholder owned more than 5% of the firm. Owner-controlled firms had at least one shareholder with a 5% or greater stake. Owner-manager-controlled firms were those firms where at least one senior manager owned 5% or more of the company. Kroll, et al (1997), using the event study methodology, found that acquisitions purchased by manager-controlled firms generated significant negative returns. For owner-manager-controlled and ownercontrolled firms, these transactions generated positive returns.

Executive Hubris Hypothesis

Another stream of research attempting to explain the dismal track record of acquisitions has focused on hubris of chief executive officers (Roll, 1986.) Hubris, or exaggerated selfconfidence, may lead to otherwise unsound decisions. Premiums paid represent a significant signal of the amount of value that the acquiring firm believes it can create via the acquisition (Hayward & Hambrick, 1997.) If CEOs believe that they can defy all odds and efficiently extract above normal returns from an acquisition, then those CEO are likely to overpay. Clearly, the role of the board of directors should serve as a check on this behavior, but when the board has a significant number of insiders on it, and when the CEO is also the board’s chairman, Hayward and Hambrick (1997) found that the relationship between CEO hubris and the size of premiums paid is particularly striking.

Top Management Complementarity Hypothesis

Some scholars have investigated the influence of two distinct top management teams’ ability work together after a corporate combination. Shanley and Correa (1992) queried whether agreement between top management teams improves expectations for post-acquisition performance. Following Bourgeois (1980), the researchers hypothesized that if the two top management teams perceived agreement and actually agreed on the strategic objectives of the acquisition, that post-acquisition performance would improve through healthy cooperation. Alternatively, if perceived and actual agreement were low, then conflict may arise that could thwart the achievement of objectives. Shanley and Correa’s (1992) results confirm these hypotheses. Datta (1991) also found that differences in top management styles had a negative influence on merger performance. Walsh (1988) investigated whether the conflict among top management teams involved in an acquisition leads to a higher turnover rate than in firms that have not gone through a merger. He found a significantly higher rate of turnover within five years of a merger. In addition, the type of acquisition – related versus unrelated – did not mitigate this relationship. The resource-based view of the firm (Barney, 1986; Kogut & Zander, 1992; Wernerfelt, 1984) claims that knowledge specific to a firm is often tacit, and not easily replaced. Losing a majority of the combined firms’ top management team may represent a hurdle so high that it is difficult to overcome. This conclusion was reinforced by the work of Cannella and Hambrick (1993). In an analysis of 96 large acquisitions, the authors conclude that, "…executives from acquired firms are an intrinsic component of the acquired firm’s resource base, and that their retention is an important determinant of post-acquisition performance." (Cannella & Hambrick, 1993: 137.) In addition, top management retention was important in related acquisitions as well as unrelated ones. Closely related to culture-based studies (see discussion below), Krishnan, Miller and Judge (1997) explored the relationship between post-merger performance and the complementarity of top management teams, where complementarity was defined as differences in functional backgrounds. Krishnan, et al (1997) found that a complementary management team was positively related to post-acquisition performance, and negatively related to the acquired firm’s top management team turnover. Organizational learning led to a successful acquisition process, according to the authors, and this learning occurred more readily and easily when the top management teams were blended. Krishnan, et al conclude that, "…it appears that organizational learning, and hence synergy, appears to be most enhanced by acquiring firms that are run by complementary top management teams and then by limiting the turnover with the two teams after the acquisition." (Krishnan, et al, 1997: 371.) Singh and Zollo’s (1998) study of the U.S. banking industry also concluded that high levels of replacement of acquired firm’s executives had a negative impact on performance.

Experience Hypothesis

It seems natural to assume that the greater the experience with acquisitions, the lesser the risk that potential value will not be captured. Haleblian and Finkelstein (1999) argue that the experience curve associated with mergers and acquisitions is U-shaped. In this study, "antecedents" refer to present conditions, while the past determinants of behavior are termed "consequences". When an antecedent is similar to past situations, generalization of past behavior should be observed. When an antecedent is dissimilar to past experience, discrimination should occur. During the first acquisition, managers have no prior experience and will therefore interpret events as unique. As experience builds, however, managers may assume that past situations are at play, failing to appropriately discriminate the current situation from previous ones. Once experience with this failed generalization is assimilated, managers develop the ability to discriminate when appropriate, resulting in the U-shaped distribution. It was also found that firms who acquired firms similar to those it had acquired in the past were better performers. Singh and Zollo (1998) demonstrate that for firms in the banking industry, the tacit knowledge acquired from previous acquisitions positively impacts performance provided that the two integration experiences are homogenous. When the type of acquisition or integration process is substantially different, caution is warranted. They argue that, "Learning curve effects in the context of highly infrequent and heterogeneous events…are heavily taxed…." (Singh & Zollo, 1998: 30.)

Employee Distress Hypothesis

Researchers also began to focus on the process of merger integration, and on the impact mergers have on employees. Buono and Bowditch (1989) hypothesized that: Some mergers do fail because of financial and economic reasons. However, because of the myriad questions about merger and acquisition success, attention has begun to shift toward human resource concerns, the cultural ramifications of merger activity, management of the overall combination process, and specific efforts aimed at postcombination integration. In fact, most of the problems that adversely affect the performance of a merged firm are suggested to be internally generated by the acquirers and by dynamics in the new entity. The reality may be that many merger- and acquisition-related difficulties are simply self-inflicted. (Buono & Bowditch, 1989: 10.) Buono, trained as an organizational sociologist, and Bowditch, an industrial and organizational psychologist, provide a much different perspective from the scholars referred to above. Their focus is on the individual experience, and how the organization can either help or hinder that experience. Because mergers and acquisitions precipitate major life changes for organizational members, and because it is these same members that can harm or enhance the outcome of the merger, they argue that attention to the human side of mergers is imperative Basic human responses such as lowered commitment, drops in productivity, organizational power struggles, office politicking, and loss of key organizational members, represent hidden costs to a merger. If managed well (i.e., in an open, honest and participative way), Buono and Bowditch (1989) argue that these costs, while not eliminated, can be minimized. Haspeslagh and Jemison (1991) also focus on the employee side of the m&a integration process. They argue that an atmosphere that stimulates peoples’ willingness to work together is critical, and that the barriers to cooperation in an m&a context that ought to be managed include fears about job security, a loss of power and resources, process changes, reward system changes, and fear of the unknown.

Conflicting Cultures Hypothesis

Another school of thought centers on the role that the two cultures, and the closely related acculturation process after a merger or acquisition, play in determining the financial success of the merger. The above human problems get exacerbated when the underlying national, corporate or business unit cultures of the two organizations are incompatible. As it relates to m&a research, however, Nahavandi and Malekzadeh (1988) provide a broad definition of culture: "…the beliefs and assumptions shared by members of an organization." (Nahavandi & Malekzadeh, 1988: 80.) There are two broad layers, or sources, of organizational culture. First is how the organization accomplishes its objectives, and the values and beliefs that underlie these routines. Also informing this "corporate" culture, however, is national culture. In addition, an organization may have multiple cultures within it. The challenges encountered when merging two different cultures is that either one or the other (or both) needs to change. The issue, then, becomes not just culture awareness, but culture change management during the integration period. The process of acculturation follows a three-stage process: contact, conflict and adaptation (Berry, 1983.) Clearly, the more quickly one can achieve adaptation, the lower the risks of unproductive conflicts. One stream of research presupposes that the more similar the cultures of the target and bidding firms, the fewer the integration and acculturation problems that will be encountered. Indeed, Chatterjee et al (1992) found a strong negative correlation between the perceived cultural differences between the two top management teams and stock market gains to the buying firm. Nahavandi and Malekzadeh (1988) argue that the process of acculturation is a function of the preferred approach for both the acquired and acquiring firm. From the perspective of the acquired firm, the desired process is driven by the degree to which it values its own culture and seeks to preserve it, and its perception of the attractiveness of the acquirer. If, for instance, the acquired firm highly values its culture and does not rate the acquirer as highly attractive, then its acculturation is likely to be "separation", in which it will seek to avoid the acquirer’s culture. From the perspective of the acquirer, the two dimensions driving the acculturation process are the degree of tolerance for multiculturalism versus seeking one, unified culture, and the degree of relatedness between the merging firms. Nahavandi and Malekzadeh (1988) generate several hypotheses about how the integration process will proceed for each possible pair of processes. For instance, "If there is congruence between the two companies regarding the preferred mode of acculturation, minimal acculturative stress will result and the mode of acculturation … will facilitate the implementation of the merger." (Nahavandi & Malekzadeh, 1988: 87.) Cartwright and Cooper (1992) performed empirical analyses of firms involved in horizontal mergers that required a significant degree of integration. They conclude that it is not cultural differences that matter per se, but rather that the two companies can work together. This, in turn, is driven by the extent to which employee individual freedom is affected. If the two cultures are distinctly different, and individual freedom declines, Cartwright and Cooper (1992) assert that problems will likely arise. They acknowledge that the closer the two cultures are to each other, the easier the acculturation process. In an effort to assess each firm’s cultural preferences before agreeing to merge, Forstmann (1998) developed a "cultural analysis" to be performed during the merger negotiations. Arguing that the process by which cultural acculturation occurs determines the success of the merger, he recommends, "...the integration strategy should be made dependent on such cultural differences, rather than only portfolio goals, as is typically done currently." (Forstmann, 1998: 58.)

Process Hypothesis

Perhaps the most comprehensive research on post-merger integration is the work done by Haspeslagh and Jemison (1991.) In discussing the challenges involved in effectively combining two firms, the authors note that, "Integration is an interactive and gradual process in which individuals from two organizations learn to work together and cooperate in the transfer of strategic capabilities" (Haspeslagh & Jemison, 1991: 106.) The key to success lies in creating an atmosphere in which this transfer can occur. Implicitly, the authors believe that even if the profitability targets are well conceived, if the process of resource or capability transfer is flawed, value creation will be seriously limited. Haspeslagh and Jemison (1991) identified three types of problems that stand in the way of capability transfer. While all acquisitions wrestled with these problems, the successful ones actively managed the underlying dynamics, while unsuccessful ones did not. "Determinism" occurs when management is unable to adjust its integration strategy in light of new information. Flexibility in acquisition integration is therefore important. Value destruction is the flip side of the value creation coin. In the process of creating value for shareholders, employees may be asked (or perceive to be asked) to destroy value for themselves. The authors report that in situations in which (employee) value was destroyed, individuals’ commitment to the firm or to making the acquisition work declined because they perceived a qualitative change in the nature of their relationship with the firm. One central decision, therefore, is when to accommodate peoples’ needs and concerns and when to press ahead. Managing the people process then becomes critical. Finally, the third integration problem is a "leadership vacuum"; unless both institutional and interpersonal leadership were provided, the possibilities for creating the atmosphere necessary for capability transfer were limited.

M&A Research on Chinese firms (CBM&A)

This following section will introduce the presence of M&A in emerging markets, specifically China. In the Western developed economies, M&A research and studies are extensive and numerous. However this is not the case in the emerging economies. As the stock markets of these emerging markets show promising growth, so too does the number and intensity of M&A transactions increase. According to Jing et al. (2011) who studied the performance of M&A in China, M&A has only started in China since 1993, and did not become popular until the late 1990s. This intensifying of M&A activity was actively promoted and enhanced by the Chinese government who made several legislative changes and reforms to increase market mobility and competitiveness of Chinese firms. These economic

One of the most notable developments in China over the past two decades has been the vigorous pursuit of market-oriented reforms aimed at enhancing the competitiveness of Chinese firms’ worldwide. The Chinese economic reform policies actively encourage Chinese firms to engage in outward foreign investments rather than only attracting inward foreign investments into China. As a result, the number of Chinese firms engaged in the outward cross-border merger-and-acquisition (CBM&A) activities has been on the rise over the recent years. Given the important role played by CBM&As, it is surprising that no study has been carried out on the motives and performance of the corporate M&As by Chinese firms in foreign countries. It is also important to point out that most of the empirical studies on CBM&As focus on the activities from developed to developing countries or to other developed countries. Relatively little attention has been given to CBM&As from developing countries to developed countries. It is therefore difficult to generalize the applicability of the conclusions drawn in the context of advanced market economies to the CBM&As conducted by firms in the Chinese emerging capitalist economy. This ought to be investigated. Despite this, a study by KPMG (1997/1998) found that only 17% of CBM&As created value for shareholders, compared with 53% destroying it. What then motivates firms to engage in CBM&As? Some of the more prominent motives are discussed in the sections that follow.

Manager utility maximisation: Amihud & Lev (1981) find that managers attempt to maximise their own utility and not necessarily that of the stockholders. They do this by engaging in unprofitable mergers with the goal of decreasing their individual employment risk, which cannot be easily diversified away.

Hubris: Roll (1986) coined the Hubris hypothesis which claimed that managers of the acquiring firm simply paid too much for the acquired firm due to overvaluing potential synergies and/or the value of the target firm. In other words, these managers show signs of overconfidence in valuing the takeover.

Synergy: Jensen & Ruback (1983) find evidence indicating that takeovers provide abnormal returns to shareholders of the acquired firm and that shareholders of the bidding firm don’t lose. They further claim corporate takeovers will be beneficial to shareholders and competition-enhancing between managers of different firms; if some are more efficient at managing a company’s assets than incumbent managers, this would be a liable takeover.

Diversification:

Market power: Eckbo (1985) brings forward the claim that mergers are an attempt at increasing a firm’s market power and in so doing generate a positive wealth effect.

Formulate proposition/hypotheses

To assert the effect of the financial crisis in 2008-2010 on the M&A activity of Chinese firms I will employ event study methodology to calculate the stock price reaction when these announcements were made. The first hypothesis as is follows:

Hypothesis 1: M&A announcements of the acquiring firm generate positive abnormal returns.

Secondly, as stock markets and legislation surrounding mergers and acquisitions in emerging markets are not as developed as in the western economies, it might be interesting to investigate the level of information leakage (i.e. insider trading) prior to these announcements. Again, this will be analysed by using event study methodology. The hypothesis is:

Hypothesis 2: There is evidence of information leakage prior to M&A announcements.

Lastly, it might be interesting to investigate the effect the payment method has on the stock price. Common literature on M&A suggests that cash-funded M&A generate higher returns than equity-funded returns due to the signalling effect. The last hypothesis will investigate this effect:

Hypothesis 3: M&As that will be cash-funded show higher abnormal returns that when primarily equity-funded.

METHODOLOGY AND DATA

In this section I will outline the methodology I used for testing my hypotheses, which is event-study methodology, and also provide similar methodologies and provide reasons for choosing the preferred one. Furthermore, I will specify how I intend on implementing the model and what its merits and disadvantages are.

Discuss your and alternative methodologies

To examine the effect the M&A announcements have on the stock price of the Chinese firms, I will use event-study methodology and compute the abnormal returns (Brown & Warner, 1985). The primary goal of an event-study is to assess the presence of abnormal returns earned by security holders during specific events. Abnormal returns are defined as the difference between observed returns during the event and the regular expected return had there been no event. These observed returns are thus benchmarked against the expected returns, which can be calculated by the use of three different techniques (Peterson, 1989): (1) Market models; (2) Mean-adjusted models; and (3) Market-adjusted models

The benchmark expected returns will be estimated using an estimation period prior to the event. Typical lengths of estimation period when using daily returns are around 100 to 300 days. There is a trade-off here, by increasing the amount of days included you increase the power of the model, but also increase the instability of the parameters. Thus the choice of estimation period largely depends on prior methods in similar research.

There is an implicit reasoning here that the market is efficient and rational and will immediately incorporate the new information of the announcement in the stock price. (source?)

Formulate the appropriate statistical tests to test your propositions/hypotheses

I will use event study methodology to regress the model based on abnormal returns and then to statistically test the significance of the results I will employ the Robust t-statistic test and the Wilxocon Z-statistic test.

Discuss measurement of your variables

According to Ma et al. (2009) the drawback of using the CAPM model to estimate the normal return is due to the requirement of risk-free returns, which is not as available in emerging markets as in western developed economies. Therefore, as previous event studies relating to China have done, I will use the market-model to estimate the normal expected returns, according to the following formula (Peterson, 1989):

Where

Rij = Return on firm i for period j;

Rmj = Return on market index for period j;

αi = Intercept;

βi = Slope coefficient;

µij = Disturbance term; and

T = Number of periods in the estimation period.

Then after calculating the normal returns, I can calculate the deviation from the norm, which is the Abnormal Return:

Where

ARij = Abnormal return on firm i period j

Furthermore, using the Abnormal returns we can calculate the Cumulative Abnormal Return:

Where

CARi(T1-T2) = Cumulative abnormal return for firm i in over the event window T2-T1.

Discuss data and data sources

I will use M&A announcements. The Erasmus Data Service Centre provides access to several financial databases. Among these there are three of which where I can extract information relevant to M&A announcements:

(1) SDC (via ThomsonOne): Contains M&A-, Private Equity and project finance data.

(2) Thomson One Banker (TOB): Financial data from annual reports, as well as data about mergers and acquisitions and IPO's. Focus is on listed corporations, worldwide.

(3) ThomsonOne (T1): Financial data from annual reports, as well as data about mergers and acquisitions and IPO's. Focus is on listed corporations, worldwide.

The drawback seems to be that these databases only include data from listed companies, which means that my sample data will be limited to only listed companies. Furthermore, I will filter my sample data according to several conditions: (1) The sample period will be restricted to 2002-2010, and the focus will be on 2008-2010. The years 2002-2008 serve as a benchmark to assert the effect of the financial crisis on the M&A activity in China. (2) The acquiring firm is a listed Chinese company and the acquired firm is listed on the American stock index. (3) Furthermore, the method of payment needs to be disclosed in order to answer Hypothesis 3. (4) I will only analyze M&A deals that acquire more than 50% of the shares, so as to focus on significant M&A deals that have a higher likelihood of appearing in the stock market news and thus generate a stock price response. (5) There is daily stock price data available for the acquiring firm of at least 120 days in order to generate a representative estimation window.

LIMITATIONS/SHORTCOMINGS

Event study methodology is by design and by its assumptions a somewhat incomprehensive method. First, drawing conclusions from the assumption that the market is efficient and that all new information will be immediately incorporated into stock prices might be overoptimistic. Especially in China, where the stock market is not as matured as in the western developed economies, the market might not be as efficient at incorporating new information as the assumption implies. Furthermore, there might be more market imperfections present, such as government legislation that might inhibit the free flow of capital or more directly block a takeover. Furthermore, event study methodology also poses some issues by its design. For example by its relatively short event window it assumes that all the value effects are taken into account, however one needs to remember that an announcement is not definitive and that there is a probability that the merger might not go through. Therefore there is some of the value affect not taken into account during the short event window simply due to the uncertainty of the deal success. (source?)