Deviation from the Target Capital Structure and Acquisition Choices

This study finds that managers take the deviations from their target capital structures into account in planning and structuring acquisitions. Specifically, firms that are overleveraged relative to their target debt ratios are less likely to make acquisitions, are less likely to fund acquisitions with debt, acquire smaller targets, pay lower premiums and receive favorable market reactions to acquisitions. Furthermore, managers actively rebalance their capital structures in anticipation of acquisitions when they are overleveraged. ∗ I would like to thank Andres Almazan, Aydogan Alti, Louis Ederington, Chitru Fernando, Jay Hartzell, Mark Leary (AFA Discussant), Scott Linn, David North (FMA Discussant), William Megginson, Michael Roberts, John Robinson, Duane Stock, Sheridan Titman, Ivo Welch, Roberto Wessels and Pradeep Yadav. I am also grateful to seminar participants at the University of Texas at Austin, at Koc University and at the AFA and FMA Meetings. 1 Traditional theories of capital structure suggest that firms have target debt ratios that are determined by balancing the costs and benefits of debt financing. However, firms deviate from their target capital structures due to debt overhang, expected inflation, transaction costs and asymmetric information. The deviation from the target debt ratio (henceforth, leverage deficit) can potentially affect corporate investment choices through two channels. First, overleveraged firms may forgo positive NPV investments in the presence of market imperfections as positive leverage deficit constrains firms raising capital to finance new projects (financial constraint hypothesis). Second, Jensen (1986) suggests that managers of underleveraged firms may make negative NPV investment choices that benefit them personally (free cash flow hypothesis). Although these hypotheses have different assumptions on motivations for undertaking acquisitions, they both suggest a negative association between acquisition activity and leverage deficit. Specifically, underleveraged (overleveraged) firms are more (less) likely to undertake acquisitions, are more likely to fund them with debt and pay higher premiums relative to a control group of firms that do not deviate from their target capital structures (moderately leveraged firms). Furthermore, both hypotheses predict the same pattern of relative acquirer announcement returns (i.e., higher acquirer returns to overleveraged firms relative to underleveraged firms). However, they do not share similar predictions on the sign of abnormal returns to underleveraged acquirers. On the one hand, the key prediction of the free cash flow hypothesis is the negative acquirer returns to underleveraged firms as managers of these firms are more likely to make poor acquisition choices. On the other hand, the financial constraint 1 See Frank and Goyal (2009) for a review of factors influencing deviation from the target capital structure. 2 Leverage deficit is defined as actual minus target debt ratio. Based on this definition, overleveraged firms have excessively positive leverage deficit (largest leverage deficit quartile), and underleveraged firms fall in the lowest leverage deficit quartile. 3 Studies on the role of financing frictions on investment decisions include, but are not limited to, Myers (1977), Greenwald, Stiglitz and Weiss (1984) and Hart and Moore (1995). 2 hypothesis suggests that overleverage prevents firms from pursuing all positive NPV projects; thereby overleveraged firms will only pursue the most value-enhancing acquisitions. These imply positive announcement returns to overleveraged acquirers at the acquisition announcement dates, but do not lead to a prediction on the sign of abnormal returns to underleveraged acquirers. In this paper, I empirically examine how the deviation from a firm’s target leverage ratio influences its firm and asset acquisition decisions and attempt to disentangle the effects of the free cash flow and the financial constraint hypotheses. I focus on acquisitions since there is detailed information about these investments, allowing an in-depth evaluation of the potential differences between the acquisition choices of underleveraged and overleveraged firms. Specifically, I examine whether a firm’s leverage deficit affects the likelihood of making an acquisition, as well as the method of payment, announcement returns and premiums paid to the target. Finally, I examine ex ante managerial decisions on capital structure prior to acquisitions. To empirically examine the effect of the leverage deficit on acquisition choices I utilize a two-step estimation procedure that is similar to Hovakimian, Opler and Titman (2001). In the first step, I estimate the target leverage ratio by running a regression of leverage ratios on the main determinants of capital structure considered in the prior studies. In the second stage regressions, I examine whether the deviation from the predicted target capital structure affects acquisition decisions. Results in this paper indicate that the estimated leverage deficit is strongly related to acquisitions choices: a one standard deviation decrease in the leverage deficit increases the likelihood of making an acquisition by 10.8% and increases the size of acquisition by 5.2 percent. However, the effect of leverage deficit on the likelihood of making an acquisition is not symmetric for underleveraged and overleveraged firms. While the effect of overleverage is 4 See, e.g., Harris and Raviv (1991); Rajan and Zingales (1995); Frank and Goyal (2004). 3 negative and significant, underleverage has an insignificant effect on the acquisition probability. The results hold for both firm and asset acquisitions and for both withinand cross-industry acquisitions. I also find significant effects of leverage deficit, which is driven by overleveraged firms, in payment choices and premiums paid to targets; overleveraged acquirers pay lower premiums and are less likely to use cash in their offers. Furthermore, acquisition announcement returns increase with leverage deficit and are significantly positive for overleveraged acquirers. Although these findings are consistent with both the free cash flow and the financial constraint hypotheses, I find evidence that contrasts sharply with the key prediction of the free cash flow hypothesis. There are positive abnormal returns to underleveraged acquirers in the short-run, and these positive abnormal returns are not followed by negative returns in the long-run. Finally, I examine whether managers attempt to mitigate the negative effect of overleverage prior to acquisitions. I find that overleveraged firms lower their leverage deficit by 3.4% relative to their peers when they have a high likelihood of acquisitions. Collectively, these findings are in line with the financial constraint hypothesis and suggest that leverage deficit affects managerial decisions on undertaking acquisitions and ex ante capital structure adjustments as well as the terms of the acquisitions. These findings complement Harford et al. (2009) who also document the role of leverage deficit in method of payment conditional on making an acquisition. I show effects of leverage deficit in the ability to make acquisitions and ex ante capital structure decisions. Specifically, a positive leverage deficit decreases the premium paid by overleveraged acquirers; thereby it unconditionally limits the ability to make acquisitions and affects ex ante capital structure changes for overleveraged firms. These findings contribute to studies on the effects of leverage 5 The free cash flow hypothesis is based on the assumption that managers of underleveraged firms make poor acquisition decisions that benefit them personally (Jensen (1986)). Thus, the hypothesis predicts strictly negative abnormal returns to underleveraged acquirers. 4 deficit on corporate policies. In particular, Frank and Goyal (2009) and Leary and Roberts (2005) report firms adjusting debt ratios more quickly when they are overleveraged. The significant effect of overleverage and the insignificant effect of underleverage on acquisitions documented in this paper suggest that a higher likelihood of forgoing acquisition opportunities may yield quicker leverage adjustments for overleveraged firms. I find further evidence confirming this prediction: overleveraged firms reduce leverage when they have a high probability of undertaking an acquisition. These findings also contribute to a growing number of studies examining the role of anticipation of investment opportunities on capital structure decisions. Specifically, Almazan et al. (2009) and Morellec and Zhdanov (2008) show that firms accumulate financial slack when they have acquisition opportunities. The findings in this paper establish a link between acquisitions and security issuance decisions through leverage deficit while extending the role of leverage deficit in security issuance to real investment decisions. This paper is also related to studies examining the role of financing frictions on corporate policies. In frictionless capital markets, firms should be able to finance all positive NPV projects with no restrictions on their forms of financing (Modigliani and Miller (1958)). However, financing frictions limit a firm’s ability to fund new investments (Myers (1977), Myers and Majluf (1984), Jensen (1986), Hart and Moore (1995)). Using acquisitions in this study allows me to test whether overleverage constrains managers in investment decisions as well as the form and the level of financing. I show that overleveraged firms are less likely to go to debt markets and are more likely to use equity to finance their acquisitions if they are able to acquire. In addition, using equity does not suffice for overleveraged firms to offer premiums as high as other firms. This, in turn, constrains the acquisition activity of overleveraged firms. Therefore, this 6 See Fama and French (2002), Flannery and Rangan (2004), and Kayhan and Titman (2007) for the role of leverage deficit in security issuance decisions. 5 study suggests that excess positive leverage deficit not only limits the access to debt markets, but also constrains the exploitation of equity market, which, collectively, decreases the acquisition activity of overleveraged firms. The paper also contributes to a growing number of studies on asset acquisitions (e.g., Hege et al. (2009)). Although previous studies discuss differences between firm and asset acquisitions by solely focusing on asset acquisitions (e.g., Warusawitharana (2008)), this study incorporates both acquisition types and reports differences as well as similarities of these acquisitions. Specifically, I find that decisions on undertaking acquisitions are influenced by the same set of factors in a similar way while there are sharp differences on how these acquisitions are financed. Therefore, the findings in this paper suggest that differences in both types of acquisitions do not affect the decisions on undertaking acquisitions while they play important roles in financing decisions. The paper is organized as follows. Section 1 provides details of sample selection and descriptive statistics of the data. Section 2 explains the determinants and estimation procedure of the target leverage ratio. Section 3 examines the empirical findings of the second stage regressions. Section 4 concludes. 1. Literature Review and Hypothesis Development Consistent with traditional theories of capital structure, Graham and Harvey (2001) report that 81% of CFOs claim to have target debt ratios, which are determined by the costs and 7 One exception to this is Almazan et al.(2009) who focus on ability to undertake firm and asset acquisitions, but do not examine the differences in financing of these acquisition types. 8 For example, relative size decreases the likelihood of cash offers in firm acquisitions while it increases percentage of cash in asset acquisitions. 6 benefits of debt financing. Firms, however, deviate from their target capital structures due to debt overhang (Myers (1977)), expected inflation (Frank and Goyal (2007)), transaction costs (Leary and Roberts (2005)) and asymmetric information (Myers and Majluf (1984)). Hovakimian et al. (2001) show that deviations from the target capital structures influence security issuance decisions. Firms that are overleveraged relative to their target capital structures are more likely to issue equity while underleveraged firms are more likely to issue debt to move their debt ratios towards their target capital structures. Deviations from the target capital structure are also likely to affect acquisition decisions. The free cash flow hypothesis suggests that managers of underleveraged firms more easily raise capital to make acquisitions benefitting them personally at the expense of shareholders (Jensen (1986)). Acquisitions, in fact, may serve in the interest of managers in many forms (Morck et al. (1990)). As managerial compensation increases with the size of the company (Murphy (1999)), managers have incentives to manage larger firms. Managing a larger corporation may also generate non-monetary benefits. For example, managing large corporations might be more fulfilling due to hubris (Roll (1986); Moeller et al. (2004)). Furthermore, career concerns may also influence managers to undertake acquisitions (Shleifer and Vishny (1989)). As human capital of managers is not diversified and is tied to the survival of the company (Amihud and Lev (1981)), managers are tempted to reduce the firm risk through acquisitions of (unrelated) targets (Morck et al. (1990)). Overall, financial slack generated by unused debt capacity may provide means for managers to undertake acquisitions which benefit managers personally, but may not be in line with economic benefits for shareholders (Lang, Stulz and Walkling (1991)). Therefore, the key prediction of the free cash flow hypothesis is negative abnormal returns to underleveraged acquirers at the announcement date. Furthermore, managers of underleveraged