An Investment-based Explanation for the Post-merger Underperformance Puzzle

Abstract

Extant evidence of acquirers' post-merger underperformance is often viewed as support for the behavioral theory of mergers that investors overvalue acquirers during the pre-acquisition period. Motivated by recent developments in asset pricing, which show that firms' expected returns and investment rates are negatively related, this paper proposes a neoclassical-based explanation for acquirers' post-merger poor returns. Acquirers are predominantly high q firms with rich growth opportunities and high investment rates, and are thus vulnerable to investment shocks. It follows that the negative investment-expected return relation is especially important in pricing acquirers. The underperformance puzzle arises because of the failure of traditional asset pricing models to account for heterogeneous impacts of investment shocks and the links between firms' investment rates and expected returns. To solve the problem, I use an investment factor-augmented Fama French model and a q theory based model to examine acquirers' long-term performance, and find the puzzle largely disappears. Rather than interpreting negative abnormal returns as evidence of overvaluation of stock-financed acquirers and high q acquirers, I show that their low returns are explained by high investment rates.