Financial Hedging and Firm Performance: Evidence from Cross‐border Mergers and Acquisitions

Author:Bo Han, Zhong Chen, Yeqin Zeng
Publication Date:01 Jun 2017
Introduction

Financial derivatives have been widely used as risk management instruments by companies around the world. Despite the popularity of financial derivatives among corporations and the theoretical groundwork in support of corporate financial hedging (e.g., Mayers and Smith, ; Stulz, ; Smith and Stulz, ; Leland, ; Froot et al., ; DeMarzo and Duffie, ), empirical findings on the relationship between corporate financial hedging and firm value are still mixed. For example, Allayannis et al. () find that the use of FCDs is positively correlated with firm value in a large sample of US non‐financial corporations with foreign currency risk exposures. Carter et al. () report a significantly positive hedging premium among a sample of US airline firms that engage in jet fuel hedging. However, Guay and Kothari () show that the cash flows generated by hedging are modest and cannot account for a large increase in firm value. Jin and Jorion () study a sample of oil and gas producers and find no significant impact of financial hedging on firm value.

In addition to the mixed findings on the relationship between hedging and firm value, empirical studies that examine the effect of hedging on firm operating activities have been surprisingly lacking. In this paper, we fill this gap by studying an important form of firm operations that is well known for changing a company's financial risk exposure: cross‐border mergers and acquisitions (M&As). By examining the impact of hedging on deal performance, we seek to contribute to the literature on whether and how risk management affects firm performance. Cross‐border M&A activities have been on the rise around the world over the last two decades as a result of deregulation and the globalisation of product and capital markets. Compared to domestic M&As, cross‐border M&As involve additional risk elements due to differences in culture, geography, capital market development, accounting rules, and regulations between the acquirer and the target countries. More importantly, taking over a foreign target significantly changes the acquirer's financial risk exposure. As shown in Figure , the timeline of M&A transactions can be divided into three stages: the pre‐acquisition period (between the start of private negotiation and the deal announcement), the interim period (between the deal announcement and completion), and the post‐acquisition period (after deal completion). An acquirer in a cross‐border M&A encounters deal‐related risk exposures at different stages. During the pre‐acquisition stage, both the acquirer and the target encounter valuation fluctuation due to exchange rate movements, which could change the target's attractiveness to the acquirer. During the interim stage, an acquirer is exposed to new foreign exchange (FX) risk if the payment is denominated in the target nation's currency. In addition, if an acquisition requires external financing, the acquirer is exposed to IR risk, which affects the deal financing costs. During the post‐acquisition stage, an acquirer faces greater FX exposures as a result of acquiring the foreign target and increased foreign operations.

Financial risks along a cross‐border M&A timeline

This figure presents a typical cross‐border M&A timeline and the associated financial risks at different phases of the deal. We define the pre‐acquisition period to be between the deal initiation date and the announcement date. During this period, acquirers and targets privately negotiate with each other. Next, we define the interim period to be between the announcement date and the deal completion date. Finally, we define the post‐acquisition period as the period after the deal completion date, which can be further divided into the integration stage and the post‐integration stage.

Pre‐acquisition period: Evaluating the target's financial risk

Interim period: Transaction risk

Transaction risk refers to the uncertainty that the US dollar value of a target's price and the external financing costs could change with the FX rate and the interest rate between deal initiation and deal completion.

Post‐acquisition period: Integration risk, balance sheet risk, cash flow risk

Integration risk refers to the uncertainty for an acquirer when designing the new financial risk management programmes of the combined entity during the integration period.

Balance sheet risk refers to the uncertainty about the US dollar value of acquired assets or liabilities due to the movement of FX rates. Cash flow risk refers to the uncertainty about the US dollar value of future operating cash flows due to the movement of FX rates.

There are four main advantages to studying the impact of hedging on firm performance through cross‐border M&As. First, this sample naturally excludes firms without FX exposure. A firm that does not have significant financial risk exposure may choose not to hedge due to the lack of hedging benefits. If a sample includes firms of this nature, then the empirical tests to examine the impact of hedging on firm performance could be compromised because they do not serve as an effective control group. By focusing on firms experiencing a significant increase in their risk exposure, we are able to conduct more effective tests to identify the potential hedging benefits. Second, this sample allows us to adopt the standard M&A event study approach, which mitigates the reverse causality concern that firms with better performance are more likely to hedge rather than hedging leading to improved deal outcomes. By examining acquirers' established derivatives contracts before their deal announcements, when firm performance is measured, this approach alleviates the reverse causality concern because it is unlikely that the M&A announcement returns are responsible for the establishment of hedging programmes in acquiring firms. Third, the event study approach allows us to examine the impact of hedging on firm performance measured by stock market reaction and firm operating performance, which offer an alternative to the firm value measure, Tobin's Q, adopted by most risk management studies. Acquirer announcement returns directly measure the acquirer shareholder wealth effect associated with hedging. Finally, being the first to directly study the effect of financial risk management on a specific type of firm operation, our results can shed light on the channels through which financial hedging improves firm value.

Our sample includes 1,369 cross‐border M&A deals announced by Standard & Poor's (S&P) 1500 firms between 2000 and 2014. The S&P 1500 index covers 90% of the US stock market capitalisation and includes firms of various sizes (S&P 500 Large Cap, S&P 400 Mid Cap, and S&P 600 Small Cap) and industries. For each deal, we manually collect the acquirer's derivatives data reported in its 10‐K report prior to the corresponding deal announcement date, following the derivatives data collection procedure of Allayannis and Weston (2001) and Bartram et al. (2011).

Our sample firms make foreign acquisitions in over 35 countries. More than 72% of these acquirers use either FCDs or IR derivatives (IRDs) to manage firm financial risks. About 63% of acquirers use FCDs and more than 37% of acquirers have FCD positions in the currencies of target nations. Our univariate tests show that derivatives users are better than non‐users in terms of both short‐ and long‐term performance. We also find that derivatives users and non‐users differ significantly in terms of size, leverage, cash ratio, stock return momentum and volatility, as well as return on assets (ROA). In addition, the use of derivatives is more prevalent among acquirers that take over large targets and use less equity as the method of payment. These differences emphasise the importance of multivariate tests.

Our multivariate tests confirm that financial hedging is positively associated with acquirer cumulative abnormal returns (CARs) during the announcement period. Hedging with currency derivatives is associated with an average 1.0% improvement in acquirer CARs, which is equivalent to an increase of US$ 193.7 million in shareholder value for an average‐sized acquirer. We also find that financial hedging has an effect on other aspects of deal outcomes. First, deals made by firms with financial hedging programmes have a higher completion probability than deals by firms without such programmes. Next, we show that it takes FX derivatives users an average of 32 days longer to complete a deal than non‐users. Our observation is consistent with the interpretation that waiting costs for derivatives users are lower than for non‐users during the deal negotiation phase. We also investigate whether the short‐run superior performance of derivatives users extends to the long run. In terms of operating performance, we find that the change in abnormal ROA (AROA) for FCD users is, on average, 0.7% higher than for non‐users over a 3‐year period after M&A deals. The improved long‐term performance related to hedging is also confirmed by measures of stock returns. Over a 3‐year horizon, FCD users experience 0.4% higher buy‐and‐hold abnormal stock returns (BHARs) than non‐users. Overall, we find strong evidence that financial hedging is related to improved deal performance for acquirers engaged in cross‐border M&As.

A major concern for the interpretation of our empirical results is that the decision to establish a financial hedging programme is not random. It could depend on omitted firm characteristics variables that could independently affect M&A outcomes. To address this concern, we employ three different methods. First, we adopt a special form of the Heckman () selection model: an endogenous treatment effect model with two‐step consistent estimates (Wooldridge, ). This approach helps us estimate the ‘treatment effect', that the superior deal performance of derivatives users over non‐users is caused by hedging instead of other unobserved variables...

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