The Reference Point Effect,
M&A Misvaluations and Merger Decisions

Abstract

This thesis investigates the reference point effect on M&As. Prospect theory proposes that the reference dependence bias is firmly rooted in people’s minds, affirming that people rely heavily on a piece of relevant information while making decisions. This thesis applies this reference point to M&As, showing that M&A participants are subject to reference-dependence bias. The reference point theory explains the M&A motives in a new way. The results of this thesis offer important implications to M&A practitioners.

Baker et al. (2012) suggest that the target’s reference price enhances the target’s bargaining power in the U.S. market, inspiring the author’s thinking that the reference point effect is likely to be reinforced in a competitive market and in the scenario where the bidder is in the face of considerable information barriers. In this pursuit, Chapter 3 studies the reference point effect on a sample of public acquisitions involving a U.K. target. Using the target 52-week high as the reference price, a positive relationship emerges between the reference price and the offer premium. Further, there is evidence of overpayment among domestic bidders whereas little evidence among cross-border bidders, indicating that the market acquiesces the payment according to the target reference point among cross-border bidders. Evidence that reference- dependence bias serves as the bargaining power is confirmed outside the United States.

However, the real M&A motive of the bidder is unlikely to be revealed solely depending on the target reference point. Therefore, Chapter 4 extends Baker et al.’s paper (2012) by adding both the target and the bidder reference points. A Relative Reference Point (RRP) is proposed for M&A misvaluations as per Shleifer and Vishny (2003), indicating the extent to which the bidder is more overvalued relatively to the target. The joint reference point effects can explain the motivation of why bidders paying high offer premiums. The results obtained in this chapter show that bidders are likely to pay with stocks when RRP increases, suggesting that bidders accelerating the process of overvaluation dilution is a sign of bidder overvaluation. In addition, the offer premium increases with the RRP, indicating the motive of diluting overvaluation is to be seen by the target, leading targets to bargain over high offer premiums. When assessing the long-term performance of stock bidders, it became evident that bidders time the market by paying stocks according to the RRP.

A direct implication of prospect theory is that people seek risk in the face of loss gauged by a reference point. Chapter 5 proposes the bidder reference point to assess the market anticipation effect. Investors suffer mental loss when their firm’s current performance is significantly below its best recently achieved performance. They anticipate that the firm will take risks to turn the table round. It was evident that the firm is rewarded with positive market reactions when it takes risks according to the market’s anticipation. In a further analysis, it also emerged that managers taking the market-anticipated risks exhibit greater efforts in the processes of M&A negotiation and post-merger integration, reflected in the low offer premiums paid to the target shareholders and positive long-term abnormal returns earned.

This thesis has empirically investigated many implications of the reference point effect in the M&A context. The main aim of this thesis is to simplify M&A decisions for managers in order to structure M&A effectively.