Mergers and acquisitions are considered an integral part of a well-functioning governance system, an effective device for transferring corporate control to more capable owners and executives who can manage firm assets more efficiently and create economic value for shareholders of target firms. Acquirers, meanwhile, aim to reap financial synergies by integrating their economic resources and operations with those of targets. All this takes time, though, which is why mergers are often considered long-term corporate investments. Nonetheless, in about $3.5 trillion worth of deals, representing 23 percent of U.S. M&A activity from 1980 to 2015, targets were resold.[1] This phenomenon casts doubt on not only the effectiveness but also the intent of M&A.
In a new study, “Acquiring to Sell: Acquisition Flippers and Earnings Management,” we investigate why acquirers resell targets over a relatively short period of time(“flipped acquisitions”). In particular, we examine whether those acquirers engage in earnings management to freshen the appeal of targets to subsequent buyers.
The flipping concept is not new on Wall Street. Private equity investors are known for their ability to raise debt, buy companies, turn them around by stripping non-essential businesses over several years, and sell them in initial public offerings (IPOs). This behavior is called “buy it, strip it, flip it.” It is worth noting that decisions on how to turn around companies are not necessarily in the best interest of future investors because private equity investors often sell their shares soon after IPO lockup periods expire. For example, on July 14, 2006, seven months after purchasing Hertz, the private equity group of Clayton, Dubilier & Rice, Carlyle Group, and Merrill Lynch Global Private Equity filed a preliminary prospectus with the Securities and Exchange Commission (SEC) for an IPO. However, just three weeks before the IPO prospectus filing, the group had Hertz borrow $1 billion to pay it a special dividend. One of the purposes of the IPO was to raise proceeds for paying off the loan. The quick IPO made the three Hertz buyout firms more like “fast-buck artists than thoughtful turnaround specialists” (Bloomberg Businessweek, August 7, 2006).
In contrast to the “buy it, strip it, flip it” practice, “flipped acquisitions” do not involve IPOs. Targets are flipped through subsequent M&A transactions in which flippers (initial acquirers) resell targets to new acquirers. In other words, acquisition flippers are not subject to stringent regulatory requirements related to IPOs and avoid costs associated with being owners of public companies, including directors and officers liability insurance premiums, Sarbanes-Oxley related audit expenses, and other governance and legal costs. Therefore, while not documented, flipped acquisitions could be more widespread than the “buy it, strip it, flip it” practice in the U.S.
Acquiring a firm to flip it is certainly different from acquiring a firm to own it long-term. As temporary owners, acquisition flippers focus on maximizing the sale prices of targets. While long-term value creation can increase sale prices, it is not feasible to enhance targets’ intrinsic value in a relatively short period of time. For acquisition flippers, a simple way to boost sale prices may be to make cosmetic improvements to earnings by, for example, manipulating accounting numbers to inflate the performance of newly acquired targets. Earnings that are merely window dressing, however, will probably not be sustainable. As indicated to us in a private conversation by an employee whose company was acquired and resold by an investment bank in less than three years, the subsequent acquirer (a private company) found it impossible to maintain the level of pre-acquisition earnings and had to undertake significant restructuring just to break even.
To identify flipped acquisitions, we hand collect targets that are resold by their initial acquirers and categorize them based on when they are resold: within one year, two years, or three years, or after three years. We consider three years or less a relatively short period of time for flipping targets, given that the median holding period by turnaround specialists like private equity firms is about six years. Consistent with the prediction that earnings as window dressing are not sustainable, we find that subsequent acquirers of resold targets are more likely to restate earnings (downward) during the post-acquisition period compared with acquirers of non-flipped targets. More important, these findings are only significant for acquisitions flipped over a relatively short period of time (within one year, two years, and three years).
Additional analyses show that acquiring flipped targets is detrimental to subsequent acquirers. Those acquirers, in comparison with acquirers of non-flipped targets, experience larger declines in operating performance, have a higher likelihood of goodwill impairment, and are less likely to acquire flipped targets in the future. Cross-sectional tests further reveal more (less) pronounced effects among targets flipped by serial flippers and professional investors (among subsequent acquirers with high-quality M&A advisors).
Overall, our study sheds light on the interesting phenomenon of flipped acquisitions in the U.S. M&A market. We show that some acquirers engage in M&A with the intent to resell targets. Rather than improving targets’ intrinsic value, these acquirers simply inflate targets’ earnings, which is value-destroying to subsequent acquirers. These results should be of interest to regulators and market participants who are interested in the effectiveness of the market for corporate control. More important, our findings should be of particular interest to firms that consider acquiring targets put up for resale within a relatively short period of time.
ENDNOTE
[1] The total transaction value of mergers and acquisitions exceeding $1 million in the Securities Data Company (SDC) U.S. Mergers and Acquisitions database is about $15.5 trillion during our sample period.
This post comes to us from professors Lyungmae Choi at the City University of Hong Kong, Shawn X. Huang at Arizona State University, and Min Kim at Sogang University. It is based on their recent paper, “Acquiring to Sell: Acquisition Flippers and Earnings Management,” available here.