The Effect of Excess Cash on M&A - Evidence from Europe

Abstract: This paper studies the development of corporate cash holdings and their effect on M&A in a European context. We observe a secular increase in corporate cash ratios which is in line with the U.S. trend. Contrary to expectations, on average, higher cash levels do not go hand in hand with positive excess cash ratios. Excess cash levels are found to have significant implications on certain M&A parameters. More specifically, a one standard deviation increase in the excess cash ratio results in a relative increase of a firm's likelihood to become an acquirer in the next year by 3.7%. Following Jensen's (1986) free cash flow hypothesis, we interpret this as an indicator of increased agency conflicts. Furthermore, for every dollar of excess cash held, unexpected acquirers are found to destroy one cent of the firm's market value of equity in the announcement period. Combined with evidence that post-merger operating performance seems to be unaffected by the cash status of the acquiring firm, this suggests that cash-rich firms tend to pay more for their targets. Possible explanations for this can be found in hubris or agency conflict arguments.