Isil Erel, Yeejin Jang, and Michael S. Weisbach
Do Acquisitions Relieve Target Firms' Financial Constraints?
Journal of Finance | Volume 70, Issue 1 (Feb 2015), 289-328

Firms sometimes face financial constraints and have to forgo valuable investment opportunities. Managers often claim that an important source of value in acquisitions is the acquiring firm's ability to relieve these constraints and help finance investment for the target firm. By being a part of a larger organization subsequent to an acquisition, the target firm can gain better direct access to capital markets through a parent firm, or can finance its investment from internally generated cash flows in other divisions. Consequently, the target will be able to undertake an increased number of profitable projects. Under such circumstances, acquisitions can create value.

In this paper, we evaluate the extent to which acquisitions lower financial constraints. This financing view of acquisitions predicts that prior to the acquisition, targets should be financially constrained, and that following the acquisition, the constraints should decline.

1: Target's Total Assets before the Acquistion (USD Million)
Completion No of Domestic Independent Private Public
year Deals Mean Median Deals (%) Targets(%) Targets(%) Acquirer(%)
2001 228 77 7.2 62.95 72.8 95.2 46.0
2002 393 126 7.7 59.07 69.7 96.7 44.3
2003 429 57 7.5 61.20 62.5 97.2 29.4
2004 603 79 8.0 62.35 70.0 97.2 38.5
2005 768 95 8.6 63.53 68.0 97.4 36.7
2006 999 49 7.2 60.20 68.8 97.7 35.3
2007 1270 38 7.3 65.51 77.5 97.7 35.0
2008 497 83 7.4 67.58 78.5 97.6 31.6
Total 5187 68 7.6 63.1 71.6 97.4 36.1

Data and Sample

Examining these predictions empirically is difficult, since for most acquisitions, one cannot observe financial data on target firms after being acquired. In addition, financial data on targets that are private and/or subsidiaries of other corporations are not publicly available in the U.S. In contrast to the U.S., most European countries require firms to report financial data publicly on an unconsolidated basis. Because of this disclosure requirement, we are able to construct a sample of 5,187 European acquisitions occurring from 2001 to 2008, each of which became a wholly owned subsidiary subsequent to the acquisition.

As documented in Table 1, most of the targets in our sample are private firms (97.4%) and they are quite small, with a median book value of assets of approximately $7.6 million. The descriptive statistics highlight that our study focuses on the firms for which an acquisition is a relatively attractive source of relieving financial constraints.

Measuring Financial Constraints in Target Firms

To assess whether financial constraints are alleviated by acquisitions requires that one can measure constraints in a particular target firm both before and after being acquired. While there are many ways to measure financial constraints, particularly useful ones come from observing managers' own actions regarding their financial position. When access to capital markets is imperfect, value maximization will lead managers to adopt financial policies that ensure that the most important investments continue to be financed. In this paper, we use the following three measures that have been suggested by the prior literature:

  1. Cash Holdings: Managers of firms that face difficulties in raising necessary capital will typically hold more cash as a precaution against coming up short in the future.
  2. Cash Flow Sensitivity of Cash: Firms should hold more of their incremental cash flow as cash if they fear that they may not be able to raises funds easily in the future.
  3. Cash Flow Sensitivity of Investment: A financially unconstrained firm should be able to undertake all valuable investments, while the quantity of investments a financially constrained firm will undertake will be an increasing function of its cash holdings.
Therefore, a decline in the target's cash holdings, its investment-cash flow sensitivity, and its cash-cash flow sensitivity following an acquisition would suggest that the target's financial constraints are reduced when a target is acquired. In addition, if the improvement in financing from acquisitions reduces financial constraints, investment should rise following the acquisition.

Main Results

Our empirical results suggest that acquisitions do mitigate financial constraints. Table 2 presents our main results.

We find that cash holdings, normalized by assets, decline by approximately 1.5% for an average target firm after being acquired. The sensitivity of cash to cash flow declines significantly from 10.4% to close to zero, which implies that the target firm goes from being constrained to unconstrained. Finally, there is a statistically significant decline in the sensitivity of investment to cash flow, with the magnitude of the post-acquisition sensitivity being less than half of that before the acquisition. All of these results are consistent with the view that acquisitions mitigate financial constraints, potentially providing a source of value by enabling target firms to improve their investment policy.

2: The effect of acquisitions on cash holdings, cash-cash flow and cash-investment sensitivities, and investment of target firms
Dependent Variable Cash/Asset δ(Cash/Asset) Investment/Asset Investment/Asset
After-Merger Dummy –0.0145** –0.0104** 0.0247** 0.0201**
(0.005) (0.004) (0.006) (0.005)
Cash Flow/Total Assets 0.1036** 0.0713**
(0.025) (0.028)
After-Merger Dummy × –0.0929** –0.0563***
Cash Flow/Total Assets (0.029) (0.033)
Firm-level and macro-level controls are always included
Observations 11,941 11,632 12,138 27,322
R2 0.672 0.195 0.368 0.315
Standard errors are in parentheses

We also find that investment does increase for target firms in our sample. Controlling for other factors, investment as a fraction of total assets increases by 2% following the acquisition, which is a substantial effect given that the mean (median) investment ratio is 6.4% (3.4%) for targets before the acquisition.

smaller targets. In addition, the reduction in financial constraints occurs in both diversifying and same-industry acquisitions. This cross-deal pattern of empirical results suggests that they reflect reductions in financial constraints rather than other factors.

Concluding Remarks

In this paper, we document that the financial management decisions of target firms change when the firm is acquired in ways consistent with their becoming less financially constrained. We find evidence that financial synergies resulting from reductions in financial constraints could motivate some acquisitions, potentially improving efficiency in investment policy of target firms.

While a reduction in financial constraints could potentially be a factor leading to acquisitions, it is not likely to be the only factor. Quantifying the relative importance of financing motivations compared to other factors is an important question for future research.