Market Misvaluation and Merger Activity: Evidence from Managerial Insider Trading

Abstract

This paper tests the empirical predictions of the market misvaluation theory of mergers advanced by Rhodes-Kropf and Vishwanathan (2004) and Shleifer and Vishny (2003) using data on managerial insider trading around merger announcements. I first present evidence of opportunistic insider trading by acquirer-firm managers prior to mergers. Acquirer-firm managers abnormally increase their selling prior to stock mergers suggesting those deals might be overvalued. I then construct a misvaluation measure based on the magnitude and direction of managerial trades prior to the merger and use it to test the empirical predictions of the misvaluation theory. To the extent that managerial trading is motivated by misvaluation, I find consistent differences in the merger characteristics and long-run returns of overvalued and undervalued firms. Overvalued firms are more likely to conduct stock mergers, have high pre-merger but negative post-merger excess long-run returns and receive negative market reaction to their acquisition announcements. My results support the theory that market misvaluation affects merger activity.