Limits to Arbitrage and Shareholder Gains in Corporate Acquisitions

Abstract

Small acquirers earn 2.5% higher excess returns when they acquire private and subsidiary targets than large acquirers. In efficient markets this empirical regularity could imply that shareholder wealth effects of corporate acquisitions diminish as firms grow supporting Coase’s theory that an optimal firm size exists where the marginal cost of internal coordination equals the marginal cost of obtaining the input from the external market. The evidence presented in this paper is consistent with the hypothesis that limits to arbitrage induce a greater positive market response to acquisition announcements made by small acquirers. Small acquirers experience higher abnormal announcement returns only in acquisitions of private and subsidiary targets: events interpreted as positive news. Greater announcement abnormal returns are associated with costlier short sales and larger abnormal trading volume resulting in larger temporary price pressure for acquirers whose shares are costlier to sell short regardless of size. The empirical evidence is inconsistent with the hypothesis of optimal firm size: large acquirers’ overpayment for the target and/or lower operating synergies do not explain the size effect in shareholder gains.