Real options’ role in M&A: from theory to practice

Abstract

Purpose of the study

According to theory of real options’ role in M&A, an acquiring company can gain value by enhancing the target company’s real options by lowering their exercise price, increasing upside potential of cash flows and allowing for improved timing of exercise or by seeking targets where real options’ value is available to a specific acquirer. This theoretical value creation potential should drive companies to seek targets with a large amount of their value attributable to real options. This thesis links theory to practice by covering the previously untouched topics of takeover risk of companies with different amounts of their value attributable to real options, development of real options for the acquiring company around the acquisition and the difference in post-acquisition performance between acquirers of real options intensive targets versus assets-in-place targets. By studying these effects, the questions whether companies indeed attempt to capture value in targets’ real options and importantly, are they capable in doing so, can be answered.

Data and methodology

The dataset of this thesis extends from January 1980 to December 2015 and includes NYSE, AMEX and NASDAQ indexes. Stock data is gathered from CRSP and linked to fundamental data from Compustat. The measurement of real options intensity is conducted by measuring the correlation between contemporaneous volatility and stock returns for each sample company based on Grullon, Lyanders & Zhdanov (2012). The companies with the strongest correlation have the largest share of their value in real options. To measure takeover risk, companies are divided into deciles based on their real options intensity. The takeover risk between these deciles is studied via logit regression model. The development of real options for the acquirers is conducted by studying the aggregate time series of the return-volatility correlation coefficient around the acquisition. Last, post-acquisition returns are studied by dividing acquiring companies into two portfolios: acquirers of real options intensive companies versus acquirers of assets-in-place companies. Cumulative abnormal returns are studied based on commonly accepted calendar-time benchmark portfolio approach to study long-term M&A returns.

Key findings

The findings of this thesis support the hypothesis that on average, companies with a larger share of their value attributable to real options are more likely to be targets of acquisitions compared to companies where value is attributable to assets-in-place. An acquiring company benefits from acquisitions in flexibility, but acquisitions are driven partly by industry-wide factors. The findings of this thesis do no support the hypothesis that acquiring real options intensive companies would result in superior returns compared to acquiring assets-in-place targets or restraining from acquisition altogether.