Ch. 3: Auctions in Corporate Finance 127
own firms are overvalued but not knowing whether this is due to market-wide or firm
specific factors, will overestimate potential synergies with acquirers. This is similar to
search-based explanations of labor market unemployment, whereby workers think that a
decrease in demand for their labor at one firm is firm-specific (when it is in fact business
cycle related) and therefore accept unemployment, thinking that their economy-wide
opportunities have not been affected. Thus, in times of economy-wide overvaluation,
target firms will accept more bids, for they rationally infer that synergy with the bidder
is high. Of course, with each merger, the market should rationally lower the price, taking
the possibility of overvaluation into account. However, this does not rapidly lead to
an end of a wave: if synergies are correlated, then merger waves can occur, because
the market also revises upward the probability that synergies forallfirms are high.
Correlation of synergies can arise out of the sort of considerations that Holmstrom and
Kaplan discuss, for example, changes in technology which increase the efficient scale
of firms. Thus, a merger wave that begins when the market becomes overvalued may
end only when the market realizes that the synergies that were anticipated are actually
not there—i.e., the wave ends with a market crash.
Rhodes-Kropf and Viswanathan’s model is one of an open auction with bidders of-
fering shares of the combined firm, similar to that ofHansen (1985a, 1985b). Multiple
bidders and cash offers are possible. High bids by other bidders imply more likely mis-
valuation in stock offers; however, since synergies are correlated, this does not cause
the wave to end. Stock-based deals are also more likely than pure cash deals in times
of economy-wide overvaluation because of the valuation errors that targets make given
the information structure. Thus, the model explains not only merger waves but also the
stylized fact that in times of intense merger activity, stock is more likely to be used as
the means-of-payment.
Shleifer and Vishny (2003)propose a theory of mergers and acquisitions which has
a similar flavor. They argue that merger activity is driven by the relative valuations of
bidders and targets and perceptions of synergies from merger activity. Suppose that
acquirer and target haveK 1 andKunits of capital, respectively. The current market
valuations per unit of capital areQ 1 andQ, respectively, whereQ 1 >Q. The long-run
value of all assets isqper unit. If the two firms are combined, then theshort-runvalue of
the combined assets isS(K+K 1 ), whereSis the “perceived synergy” from the merger.
In other words, “Sis the story that the market consensus holds about the benefits of
the merger. It could be a story about [the benefits of] diversification, or consolidation,
or European integration”. SupposePis the price paid to the target in a merger. If the
means of payment is stock, it is easily checked thatlong-runbenefit to the bidding firms’
shareholders isqK( 1 −P/S)and that to the target shareholders isqK(P/S− 1 ).^39
Thus, ifS>P>Q, bidding firms’ shareholders benefit in the long run but target
(^39) Since the synergy is only in the mind of the beholder (the market), the long term benefit to the bidding
firms’ shareholders from a cash offer would beq(K+K 1 )−PK < qK 1 sinceP>Q>q.Onthe
other hand, if the synergy were real, a bidding firm would have no reason to prefer stock over cash. Thus,
a large number of stock offer during a particular period should reveal to the market that the synergies are