‘Significantly positively biased’ earnings forecasts reduce bid premiums and boost chance of quick merger completion, finds study co-authored at CJBS

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It pays to be optimistic if you’re a company swallowing up another firm in a stock-based acquisition, finds a study of big U.S. merger deals co-authored by Amir Amel-Zadeh, University Lecturer in Finance at Cambridge Judge Business School.

We found that earnings forecasts by bidders positively affect perceptions of target shareholders, reducing bid premiums, but also positively influence the bidding firm’s own shareholders.

Post-merger earnings forecasts by companies making stock-financed acquisition bids are “significantly positively biased” compared to pre-bid guidance, and these rosy forecasts serve to reduce bid premiums, make it more likely a bid will succeed, and speed deal completion, finds the study of big U.S. merger and acquisition deals over a 17-year period.

Despite potential costs including litigation risk and disclosure of proprietary information, among bidders there are clear “incentives to issue optimistic merger forecasts – in order to get the deal done,” concludes the study, which is based on nearly 500 of the largest U.S. takeover filings or announcements between 1990 and 2007, all exceeding $100 million and among the 50 biggest deals in each year.

The issuance of earnings forecasts by bidding companies increases by nearly 50% the likelihood that an acquisition will be completed (78% for deals with forecasts compared to 53% for those without, when other firm and deal characteristics remain constant); reduces time of completion by 41% (compared to an average of six months); and results in merger premiums up to 12% lower (compared to the average merger premium being 30%) than in deals lacking such forecasts, says the study.

These benefits of forecasting only accrue, however, to acquiring firm managers who in years prior to a deal have built a “credible forecasting reputation” in their regular guidance. The study also found that such previously credible forecasters show a “weaker” positive bias in bid forecasts. (Among all managers, the positive bias is not statistically significant for cash-based deals.)

“We found that earnings forecasts by bidders positively affect perceptions of target shareholders, reducing bid premiums, but also positively influence the bidding firm’s own shareholders because the disclosure tends to attenuate the generally negative market reaction to stock-based acquisitions,” says co-author Amir Amel-Zadeh, University Lecturer in Finance at Cambridge Judge.

“Bidding firms are more likely to disclose positive forecasts in stock-based acquisitions when their own valuation is high, because this is a time when target shareholders may be concerned about receiving overvalued shares.”

So given all these benefits, why don’t all bidding companies disclose earnings forecasts? (Among deals examined in the study, there were forecasts in around 40% stock-only or mixed bids and only 19% of cash-only deals.)

The study identified several factors, including the risk of shareholder lawsuits from positively “hyped” forecasts, the cost of disclosing proprietary information and a reluctance to issue forecasts in deals when there are competing bids.

Yet, the study concludes that it “seems that the benefits of positive forecasts during mergers outweigh the reputational and litigation concerns particularly for firms with high forecasting credibility. The incentives to issue optimistic merger forecasts – in order to get the deal done – seem therefore higher than the incentives in regular guidance.”

The study measured whether merger pronouncements are optimistic by comparing merger-announcement earnings forecasts with actual results (usually in the first full year after a deal’s closing) or analysts’ updated forecasts after the merger.

The study – entitled The Benefits and Costs of Managerial Earnings Forecasts in Mergers and Acquisitions – is co-authored by Amir Amel-Zadeh and Geoff Meeks of University of Cambridge Judge Business School, and by Baruch Lev of New York University Stern School of Business.

To download the full study: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2198958

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Charles Goldsmith