Do Acquisitions Relieve Target Firms' Financial Constraints?
Acquisitions mitigate financing constraints, potentially providing a source of value by enabling target firms to improve their investment policy.
Managers often claim that an important source of value in acquisitions is the acquiring firm's ability to finance investments for the target firm. Firms will sometimes forego valuable investment opportunities because of financial constraints; through acquisition, the target firm can gain better access to capital markets through the parent, or can finance new projects using the parent's cash flow.
In Do Acquisitions Relieve Target Firms' Financial Constraints? (NBER Working Paper No. 18840), co-authors Isil Erel, Yeejin Jang, and Michael Weisbach evaluate these predictions using a sample of over 5,000 European acquisitions that occurred during 2001-8. The disclosure requirements in European countries make available data on the financial statements of targets before and after acquisition, as long as the target remains an independent subsidiary following the acquisition. The authors thus are able to measure each target firm's cash and investment policies both before and after the acquisition, and to evaluate the extent to which the acquisition led to improved access to capital.
They find that target firms indeed are constrained prior to acquisition, and that the constraints are lessened after the firms are acquired. In particular, cash holdings decline significantly after acquisition. When access to capital markets is imperfect, managers will adopt financial policies that ensure that the most important investments will continue to be financed, notably by holding more cash on their balance sheets. Therefore, lower cash holdings are in line with lower financial frictions for the target firm after acquisition.
Moreover, the data show that after acquisition, target firms save less cash out of incremental cash flows, and that the target firm's investments tend to be less correlated with cash flows. All of these results are consistent with the view that acquisitions mitigate financing constraints, potentially providing a source of value by enabling target firms to improve their investment policy.
These effects are larger when the target is most likely to be constrained prior to the acquisition, for example when the acquired firm is independent rather than the subsidiary of another firm, or when the target firm is small. In addition, the reduction in financial constraints occurs in both diversifying and same-industry acquisitions, suggesting that the results truly reflect reductions in financial constraints rather than other factors. Consistent with the financing view of acquisitions, investment by target firms increases substantially after acquisitions.