Leverage Deviations and Acquisition Probability in the UK: The Moderating Effect of Firms’ Internal Capabilities and Deal Diversification Potential

• DOI: http://doi.org/10.1111/emre.12307
• Date: 01 December 2019
• Published date: 01 December 2019

Leverage Deviations and Acquisition

Probability in the UK: The Moderating Effect

of Firms’Internal Capabilities and Deal

Diversification Potential

HENRY AGYEI-BOAPEAH,

1

DEBORAH OSEI

2

and MICHAEL FRANCO

3

1

University of York, The York Management School, York, UK

2

Queen Mary Universityof London, School of Business and Management, London, UK

3

Liverpool John Moores University, Liverpool Business School, Liverpool, UK

In the context of mergers andacquisitions, we provide evidence to suggestthat a firm’s deviation from its optimal

financial leverage may impede its ability to undertakefuture expansions. We also findthe negative effect of leverage

deviation on acquisition probability to be moderated by firms’existing capabilities. Further, we find those deviating

firms to havebetter prospects of achievinggrowth when they pursuecross-industry and/or cross-country mergersand

acquisitions.Overall, our findingsimply that deviations fromthe optimal financial leveragemay be costly to firms but

this cost is not symmetric across all firms and all deal types.

Keywords: optimalleverage; industrial diversification;geographic diversification;internal capabilities; mergersand

acquisitions (M&A)

Introduction

The link between corporate financial and diversification

strategies has long been an important research issue in

the finance and management literature (see Barton and

Gordon, 1988; Doukas and Kan, 2008; Agyei-Boapeah,

2015; Krapl, 2015). For instance, Barton and Gordon

(1988) propose that since a firm’s diversification strategy

may reflect the risk appetite of top managers,

diversification should be related to financial leverage.

This paper contributes to this literature on the leverage-

diversification link by investigating how committing to

undertake diversifying acquisitions (relative to non-

diversifyingones) may influence the financingconstraints

that may be faced by firms thatdeviate from their optimal

(target) leverage ratios.

1

Drawing on the trade-off theory of capital structure

(see, Myers, 1977; Uysal, 2011) and the managerial

inefficiency theory of mergers and acquisitions (M&As)

(see Manne, 1965; Jovanovic and Rousseau, 2002), we

argue in this paper that extreme deviations from the

optimal leverage ratio (i.e., leverage deviations) may

represent an inefficient management action which can

hamper the initiation and successful completion of

M&As. Despite theoretical predictions, the direct link

between leverage deviation and the ability to undertake

M&As remained largely unexplored until recently when

Uysal (2011) utilized data on US domestic acquisitions

to show that firms with leverage deviations are unable to

aggressively bid for acquisition targets, which ultimately

impedes their ability to complete domestic acquisitions.

The present paperrelates to, but also differs in a number

of ways from the prior studyby Uysal (2011). First, while

the prior studywas restricted to only domesticacquisitions

made by US firms, this paper examines the link between

leverage deviation and acquisition probability within a

framework that incorporates both domestic and cross-

border acquisitions. Given the surge in the volume of

cross-border acquisitions from 23% in 1998 to about

45% in 2007 (Erel et al., 2012), and the fact that cross-

Correspondence: Henry Agyei-Boapeah, The York Management School,

Universityof York, Freboys Lane, Heslington, York, Y0105GD, UK. E-

mail: henry.agyei-boapeah@york.ac.uk;boapeah@yahoo.com

1

Although ‘target leverage’and ‘optimal leverage’are used synonymously in

thefinance literature,in this paper about M&As, we restrictourselves to the term

‘optimal leverage’in order to avoid any potential confusion of erroneously

interpretingthe target leverage to mean theleverage of the acquired firm.This

confusion may arise because the ‘acquired firms’are often referred to as the

‘target firms’inthe M&A literature.

DOI: 10.1111/emre.12307

©2018 European Academy of Management

European Management Review, Vol. 16, 10 9 –, (2019)

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border acquisitions tend to be larger and rely more on

external finan cing (Agyei-Boape ah, 2015), the ex clusion

of cross-border acquisitions from the prior study presents

a partial view of the association between leverage

deviation and acquisition probability. This paper is,

therefore, the first to present a relatively more complete

view of the link between leverage deviation and

acquisition probability by examining both domestic and

cross-border acquisitions.

Second, to date, mostof the existing empirical research

on leverage deviation has been conducted in the US

context. The extent to which the explanations offered in

the US context hold in other countries remains largely

unknown. A notable exception is the recent study by

Ahmed and Elshandidy (2018) which explores why

overleveraged British firms prefer foreign over domestic

acquisitions. While they make an important contribution

to the leverage deviation literature from a UK context,

their focus and approach did not permit them to directly

address the primary issue of acquisition probability (i.e.,

the ability to successfully undertake acquisitions), as well

as tackle how other forms of leverage deviations (i.e.,

underleveraging, moderate- and extreme-leverage

deviations) might differently impact acquisition

probability. Our paper directly addresses these issues

within the UK context, thereby, offering results that can

easily be compared with prior US findings.

Like the US, the UK is very active in the market for

corporate control, which offers us sufficient M&A

observations for a robust analysis. The UK, for example,

was the largest acquiring country globally in 2000

(UNCTAD, 2000). Therefore, the contribution we make

to the literature by focusing on UK firms is significant

because due to the institutional heterogeneity across

countries, capital structure decisions tend to vary across

countries (Rajan and Zingales, 1995; Antoniou et al.,

2008). While theUK has a vibrant market-based financial

system which is similar to the US (see Antoniou et al.,

2008), the UK’s capital market is relatively smaller and

less liquidthan the US, suggesting that financialconstraint

may be a more seriousproblem for UK firms compared to

their US counterparts.

2

Third, despite the possibility for investors to react

differently to various types of investment projects, prior

studies on the link between leverage deviation and

financing/investments have often failed to distinguish

between the impact of firms’leverage deviations on

diversifying and non-diversifying investments (e.g.,

Hovakimian et al., 2001; Kayhan and Titman, 2007;

Harford et al., 2009; Uysal, 2011). Ahmed and

Elshandidy (2018) show that overleveraged firms are

more likely to diversify globally to create value for their

shareholders,implying that investors may be morewilling

to fund M&A deals that expand the firms’global

diversification. Our paper adds to this literature by

suggesting that since some investors find merit in

synergistic diversification moves (see Lewellen, 1971;

Doukas and Kan, 2008), while others frown upon

diversifying expansions (e.g., Lang and Stulz, 1994),

firms with leverage deviation that undertake M&As may

face relatively lower or higher costs depending on the

diversification characteristic of the proposed M&A deal.

It is noteworthy that our contribution in this respect is

not limited to global diversification, but extends to

industrial diversification as well.

Finally, we draw on the resource-based view (RBV) of

the firm (see Barney, 1991; Teece et al., 1997) to

investigate how the effect of leverage deviation on

acquisition probability may be conditional on the firm’s

internal capabilities such as management skills/ability,

organizational culture/processes as well as technological

know-how and innovation. These firm-idiosyncratic

capabilitiesare not only a source of competitiveadvantage

but could also be crucial in making M&As a real value-

enhancing strategy. Thus, we posit that firms with

superior existing (non-financial) resources/capabilities

may be able to reduce the leverage deviation costs and

consequently mitigate any potential impacton acquisition

ability. This finalcontribution that we seek to make to the

literature is novel since, to the best of our knowledge and

extensive literature search, the prior related studies, thus

far, have not addressed it.

Our empirical analysis provides evidence to suggest

that inefficient (sub-optimal) managers who disregard

their firms’optimal leverage ratios tend t o have a

significantlylower ability to undertakeM&As. We further

find that the costof deviating from the optimal leverage is

asymmetrically higher for: (1) overleveraged firms

relative to underleveraged firms; and (2) extreme deviant

firms relative to moderate deviant firms. In addition, we

find the negative effect of leverage deviation on

acquisition probability to be moderated by firms’existing

levels of (non-financial) resources/capabilities. Finally,

we find that firms with leverage deviation have a better

chance of completing diversifying acquisitions (i.e.,

cross-industry and cross-border acquisitions) relative to

non-diversifying acquisitions (i.e., within-industry and

domestic acquisitions). These findings have important

implications for both theory and practice in corporate

policy. Firstly, the results provide support for the

relevance of the optimal leverage ratio and the trade-off

theory of capital structure, as well as, the inefficient

management theory of M&As by suggesting that

deviations from the optimal leverage may hinder firms’

2

The 2012 data from the World Development Indicators of the World Bank

suggeststhat the financial market inthe US is about nine times biggerthan that

of the UK, when the size of the financial market is measured by market

capitalization (i.e. $21.4 trillion vs. $2.5 trillion). The data also suggest that

the US has a more liquid financial market compared to the UK (i.e., stock

turnover ratiosof 125% vs. 84%).

H. Agyei-Boapeah et al.

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