Cash Acquirers: Can Free Cash Flow, Debt and Institutional Ownership Explain Long Run Performance?

Abstract

Cash acquirers are an interesting sub-group of acquirers. Whereas the overall evidence seems to suggest the majority of mergers and acquisitions destroy shareholder value in the long term, cash-financed acquisitions do not appear to do so. Yet this seems at variance with the prediction from Jensen’s “free cash flow” (FCF) hypothesis, which argues that high levels of free cash flow and unused borrowing capacity are likely to encourage low-value mergers. In contrast, the “pecking order” theory offers a different perspective, where managers conserve cash flow to undertake positive NPV investments. Furthermore, having adequate financial resources available post-merger may be important in developing the potential opportunities that the merger brings. We argue that the stronger position of shareholders, as opposed to firm managers, in the UK compared to the US makes the FCF hypothesis less relevant in the UK, and show that low leverage and high FCF may be advantageous provided shareholder monitoring is adequate. By analysing both announcement period and long term returns, we show that acquirers with high levels of FCF are superior performers, and that any long-run under-performance of cash acquirers appears to be associated with low cash resources and low institutional ownership.