The announcement of merger and acquisition activity represents an ‘event’ and the subsequent reaction by the participating companies’ share prices constitutes useful data in analysing the market’s initial perceptions to the overall success of the proposed transaction.
Event study methodology is designed to statistically determine whether an event has caused cumulative positive or negative returns relative to normal expectations for the company’s share price in question relative to market movements. Peirson et al (1990) note that there are many variants of event-study methodology but, for each ‘event’ it is important to establish:
• What is the information? • When was it announced?
• Were there abnormal returns associated with its announcement?
They note that an important concept is that first, the information provides
information only if it differs from market’s expectations at that time. Otherwise, in an efficient market the effects of the information will already be reflected in the share price before the announcement.
Second, it is important to identify accurately the event date because the market may react in anticipation of the announcement as investors revise their expectations. The market should also react at the time of the announcement to any unanticipated information. However, the market should not continue to react after the date of the announcement because its response should be instantaneous and unbiased.
Finally, it is necessary to calculate the response of the market to the announcement, for example, as the percentage change in share price in excess of (or below) what would normally be expected to occur.
MacKinlay (1997) has reviewed event study methods and outlines the procedures involved. The null hypothesis in event studies is that the event has no impact on the
distribution of returns. He also notes that the event window often includes the day of the announcement and the day following the announcement although in practice it is often expanded to multiple days. Andrade et al (2001) note that there are two
commonly used event windows; the three days mentioned above or alternatively a longer window beginning several days prior to the announcement and ending at the close of the merger.
The abnormal return is the actual ex post return of the security over the event window minus the normal return of the firm over the event window. The normal return is defined as the expected return without conditioning on the event taking place. For firm i and event date t the abnormal return defined by MacKinlay (1997) is: ) / ( it t it it R E R X AR = − Where = it
AR Abnormal returns for time period t =
it
R Actual returns for time period t )
/ (Rit Xt
E = Normal returns for time period t with is conditioning information for the normal return model
t
X
MacKinlay (1997) also notes that there are two common choices for modelling the normal return – the constant mean return model where is a constant, and the market model where is the market return. The constant mean return model, as the name implies, assumes that the mean return of a given security is constant through time. The market model assumes a stable linear relationship between the market return and the security return.
t
X
t
X
An estimation window needs to be defined in this type of model and MacKinlay (1997) states that the most common choice is using the period prior to the event window. He cites an example that in an event study using daily data, the market model parameters could be estimated over the 120 days prior to the event. Generally the event period itself is not included in the estimation period to prevent the event
from influencing the normal performance model parameter estimates. Recent returns analysis in mergers and acquisition by Hackbarth and Morellec (2008) focused on a 90-day estimation period prior to a three day event window (one trading day before and after the announcement). In a recent Australian study Maheswaran and Pinder (2005) used a 70-day period either side of the announcement date using a modifed market model with the market return based on the All Ordinaries Accumulation Index.
This thesis tailors an event study methodology for resource companies in Chapter 5 as part of the analysis of resource mergers and acquisitions. Many recent takeovers involve schemes of arrangements (see Section 2.6.2.2) which can involve a gradual de-risking of the transaction and abnormal returns may not be evident due to positive incremental returns which are not individually abnormal but correspond to increasing market confidence that the target shareholders will agree to the scheme and which culminates with the final shareholder vote. This is exemplified in the Xstrata plc scheme of arrangement with MIM Holdings Limited in 2003 and which delivered low cumulative abnormal returns relative to the final offer price premium over the 30-day average share price prior to the initial announcement of a potential takeover (see Appendix 1).
As a last word in this chapter on event study methodology, MacKinlay (1997) notes that economic models (e.g. CAPM, APT) have been used to constrain statistically based normal return models. He comments that while CAPM was common in event studies of the 1970s, market discrepancies with the CAPM question the validity of the CAPM restrictions imposed on the market model and hence the results of the studies may reflect the influence of these restrictions. However, as this risk is avoided by using an unconstrained market model, the use of the CAPM based event studies has almost ceased.
Similarly, other studies have employed multifactor normal performance models motivated by the APT. MacKinlay (1997) notes that a general finding with APT is that the most important factor behaves like a market factor and additional factors add relatively little explanatory power. Overall, he reports that the gains from using an APT adjusted model versus the market model are small and not warranted.