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THE JOURNAL OF FINANCE. VOL XLV, NO. 2.JUNE 1990 Anomalous Price Behavior Around Repurchase Tender Offers JOSEF LAKONISHOK and THEO VERMAELEN* ABSTRACT This paper reports anomalous price behavior around repurchase tender offers. buying shares before the expiration date of a repurchase tender offer and tendering to the firm roduces, on average, abnormal returns of more than 9 percent over a period shorter han one week. In addition, we find that repurchasing companies experience econo cally and statistically significant abnormal returns in, the two years after the repurchase The upward price drift is mainly caused by the behavior of the small firms in the sample STOCK REPURCHASE TENDER OFFERS have been analyzed extensively by Dann (1981), Masulis(1980), Rosenfeld(1982), and Vermaelen (1981, 1984).These event studies focus on explaining the abnormal price increase around repurchase tender offer announcements. After testing for the relevance of (personal and corporate)tax savings and benefits arising from expropriation of creditors Danr and Vermaelen conclude that the abnormal returns following the announcement are best explained by the information signalling hypothesis. Empirically, the signalling explanation seems to work well for relatively small firms. This is not surprising considering that small firms receive less attention from analysts and are more likely to be undervalued. However, casual empiricism suggests that, in recent years, repurchase tender offers have been made by much larger firms often in the context of hostile takeover bids. Jensen(1986a)argues that these repurchases are an effective way to eliminate excess"free"cash flow that would otherwise be wasted by management. Stulz(1988)argues that repurchases consolidate voting power in the hands of management. This might benefit shareholders by forcing bidders, in successful bids, to pay a higher price for the College of Commerce and Business Administration, University of Illinois at Urbana-Champaign and INSEAD, respectively. Theo Vermaelen is also Hoogleraar at the University of Limburg We are grateful to Peter Bossaerts, David Brown, Frank Buckley, Louis Chan, Harry De angelo, Steve oerter, Paul Halpern, Pierre Hillion, Myron Gordon, David Ikenberry, Han Kim, Chuck Link ene Stulz midt, and an anonymous referee for their helpful comments and to andy chen nd Mark Ready for research assistance. This paper has been presented at the Western Finane ssociation meetings in Seattle, at the European Finance Association meetings in Istanbul, at a nference on Reappraisal of the Efficiency of Financial Markets in Sesimbra, portugal, at a conference on portfol ent at the European Institute for Advanced Studies in Management ty of Alberta, Ur ty of California University, INSEAD at Urbana-ch School of Economics tration in Helsinki, University of michigan, University f Western Ontario, UCLA, the London Business School, and the Stockholm School of Economics. We would like to thank the seminar participants for their comm 455

The Journal of finance target shares. These theories imply that repurchase tender offers can increase real cash flows as opposed to the perceived cash flows of the signalling hypothesis While this paper sheds some light on the changing motivation behind buybacks we are mainly concerned with the implications for investment management: is it possible to make abnormal returns by trading around repurchase tender offers? There are two reasons why buybacks provide an interesting setting in which to examine market efficiency; these reasons correspond to the two types of trading strategies we test. First, a repurchase tender offer creates substantial price uncertainty and therefore more opportunities for potential mispricing. In order to price securities properly during the tender offer period, investors have te estimate 1)the fraction of shares tendered, 2)the subsequent repurchase decisions by the management, and 3)the market price after the expiration of the offer. Hence, the first trading rule tests for profit opportunities during the offer period Specifically, we test whether it is possible to make abnormal returns by buying shares before the expiration date and then tendering those shares to the company. This trading rule mimics the behavior of risk arbitrageurs who typically buy and tender during the offer period. For example, Weinstein(1984), a money manager, states that the investor must keep accurate statistics of the daily trading volume from the time of the announcement of the self-tender until the early pro rata date or registration date of the offer as an indication of how many shares are likely to be tendered. Most of the stock will have been bought by arbitrageurs Larcker and Lys(1987) conclude that risk arbitrageurs earn substantial returns n their trading activities around mergers, intra- firm tender offers, and voluntary liquidations. They argue that risk arbitrageurs are able to generate private information regarding the success of corporate reorganizations. Alternatively one could argue that these excess returns are fair compensation for the services that arbitrageurs provide in takeover bids(Jensen(1986b). Arbitrageurs 1)help to evaluate alternative offers, 2)provide risk-bearing services for investors who would rather sell than bear the uncertainty surrounding the offer, and 3)resolve the free-rider problems of small, diffuse target shareholders who cannot organize to negotiate directly with the bidder. In the case of repurchase tender offers mainly the second service is relevant The second reason for examining market efficiency follows from the result presented in previous studies. Vermaelen(1981)reports that, on average, tend- ering shareholders receive a premium of 23 percent, while nontendering share olders obtain a rate of return of only 13 percent. The nontendering group includes the management of the company which implies that insiders apparently give away"part of the firm to outsiders The increase in the bid price decreases the probability of a successful bic egative impact on firm value. Hence, according to Stulz, the repurchase might increase or decrease rm value, depending on which effect is more important. If managerial holdings are typical in larger firms, the bid price effect might dominate 2 See Weinstein(1984), p 5 At least part of the abnormal return can probably be attributed to illegal insider trading activity

Anomalous Price Behavior Around Repurchase Tender offers 457 One explanation for this behavior is that there might be offsetting benefits fo ent team to compensate for the expropriation of their persona holdings. For example, the repurchase may present an impediment for a potential takeover bid thereby permitting managers to preserve their jobs(Bagwell( 1988) Bagnoli, Gordon, and Lipman( 1987), and Vermaelen (1984). A further benefit to insiders might stem from buying shares before the announcement( Choi 1987)) An alternative to the offsetting benefit explanation is that the market does not fully adjust to the signal conveyed by the offer and therefore underestimates the true"value of the shares. This implies that buying shares after a repurchase tender offer might be a profitable investment, especially in cases where the signalling hypothesis may be most relevant, such as in small firms. 4 Hence, the second trading rule involves buying and holding shares after the expiration date of a repurchase tender offer. Interestingly, in a recent Fortune magazine article Loomis (1986)argues that buying stocks after a repurchase announcement generated annual abnormal returns (over the s&p 500)of 8.5 percent in the period 1974-198 The remainder of this paper is organized as follows In Section I we describe the data base. In Section II we test the first trading strategy: buying stocks before the expiration date whenever the market price is substantially below the tender price, tendering the shares to the firm, and selling the nonrepurchased shares in the market. This simple strategy generates economically and statistically signif- icant abnormal returns of 9 percent on average over a period shorter than one week In Section IIi we examine whether the abnormal returns can be explained by the behavior of management in oversubscribed offers. In Section IV we test the second trading strategy: buying shares after the expiration of the offer. This strategy, over a two-year period following the repurchase outperforms the value weighted index by 12 percent per year. After controlling for size and beta, the abnormal returns fall by more than half but are still significantly positive. Further investigation reveals that these abnormal returns are mainly caused by small firms. These firms were apparently able to buy back their shares at significant discounts from their "true"value. Section V summarizes our results I Data The data base consists of the announcement and expiration dates, the terms (fraction sought and tender price), and outcomes(fraction tendered and fraction purchased) of practically all 258 repurchase tender offers which occurred between 1962 and 1986 by firms traded on the NYSE, AMEx, and OTC. Data for the period 1962-1977 were adopted from Vermaelen( 1981)and include 131 obser vations. Data for 1978 and 1979 were taken from the Wall Street Journal Index Thich started summarizing repurchase announcements in 1978. From 1980 or we had access to all the 13-e4 filing and amendments made with the Security 4We assume that, eventually, with disclosure of financial information about the firm, the market ill be able to assess the"true"value of the shares S A small number of companies were eliminated from the sample because of missing data, mainly

The Journal of finance Table I Descriptive Statistics of the Sample Mean values (in percent)of the terms, the outcomes, returns to nontenderin shareholders, and returns to all shareholders for a sample of repurchase tender offers. The premium (in percent)is defined as the tender offer price minus the price five days before the announcement, divided by the price five days before the announcement. The CAR (in percent)is computed from five days before the an nouncement until ten days after the expiration. The benchmark portfolio is the equally weighted market index. TOTALR is the weighted average abnormal return (in percent)where the weights are Fp for tendering shareholders and(1-Fp)for Period 1962-19861962-1979 0-1986 Fraction of shares sought(Fs) 17.06 15.68 1907 Fraction of shares purchased 16.41 15.45 83.60 Premium 21.79 18.54 Cumulative abnormal return to 12.54 tendering and non-tendering and Exchange Commission. These filings contain basic information about the offer and the outcome of the offer. We used the filing date to track the announce ment date in the Wall Street Journal. If no record of announcement was found in the Wall Street Journal, a questionnaire was sent to the corporation. In these cases, we also searched for an advertisement of the offer in the Wall Street Journal and compared the announcement date to the filing date. Dutch auction repurchases, repurchases intended to reduce small shareholder servicing costs, or repurchases conditional on a minimum number of shares tendered were deleted from the sample. 6 The source for daily stock returns for NYSE and AMEX stocks was the CRSP data base. Data on the daily trading volume for NYSE and AMEX stocks were obtained from the Cornell University Price and Volume File (CUPV).(For a more detailed description, see Lakonishok and Smidt(1984). Data on the OTc stocks (including trading volume)were collected from the Standard and Poor's Daily Stock Price Record Table I provides a number of descriptive statistics for 221 observations for which all the data were available. On average, firms offered to buy back 17.06 percent of their shares at a premium of 21. 79 percent above the market price five During our sample period, we have very few cases in the offer was conditional on a inimum number of shares tendered. Such offers might be eived as more risky. Therefore, to control for risk of our trading strategy, these few cases were

Anomalous Price Behavior Around Repurchase Tender Offers days before the repurchase announcement. On average, 16.41 percent of the shares outstanding were purchased, but a much larger fraction(87 percent)of the shares tendered was purchased by the company. apparently, many investors decided not to tender their shares. By tendering shares, investors realize capital gains which are substantial if the base price is low relative to the tender offer price. Therefore tax considerations might explain why many investors do not tender. However, tax considerations are unlikely to provide a full explanation given the widespread ownership of shares by tax-exempt institutions. We also computed the cumulative average abnormal return to the nontendering shareholders from five days before the announcement until ten days after the expiration date(CAR)and the weighted average abnormal return to the tendering and nontendering shareholders(TOTALR). On average, nontendering share- holders earn an abnormal return of 12. 54 percent, which is significantly smaller than the 21. 79 percent premium that the tendering shareholders receive. Because on average, 16.41 percent of the outstanding shares are repurchased, the repur chase announcement increases the total value of the firm by 14.29 percent (TOTALR) To test for the stability of the results, we divided the sample into two subperiods: 1)1962-1979, which approximately corresponds to the period exam ined in past research, and 2) the more recent period, 1980-1986. Table I shows that, in the second subperiod, returns to both the tendering and nontendering shareholders became smaller. We elaborate on these results later Il Trading Rules Around the Expiration Date A Methodology In a repurchase tender offer, firms offer to buy back a fraction of their shares at a tender price, Pt, before a specific date(the expiration date). The first trading rule consists of buying shares before the original expiration date and tendering to the firm. In order to compute the gains from such a strategy, it is important to keep in mind the rules governing the repurchase tender mechanism If the offer is undersubscribed (i. e, the fraction of shares tendered, FT, is less than the fraction of shares sought), the firm will repurchase all shares tendered. This is true even when the offer is extended and becomes oversubscribed later on. If the offer is oversubscribed, the firm will either buy back all the shares endered or allocate pro-rata so that each shareholder sells the fraction Fn/Frof his or her shares to the company(where Fp is the fraction purchased Thus, the profit from buying a stock at a price PB during the tender period and tendering it to the firm is equal to Pr- Pb if the offer is undersubscribed at The benchmark return used was based on the CrsP equally weighted market index. Because of the short period, the results are not sensitive to the various methods of computing abnormal returns An offer may be extended. In our sample, 99 of the 258 offers were undersubscribed at the initial expiration day: 43 were extended and 1l of these became subsequently oversubscribe g To reduce shareholder servicing costs, companies in many cases buy all the shares from the hareholders who tendered a small number of shares, typically 100 or less. However, this has a very small impact on the F/Fr ratio

The Journal of finance the first expiration date. For oversubscribed offers(at the first expiration date) the profit from the trading strategy is Py(F/FT)+ PE(1-Fp/FT)-PB where Pe is the price after the expiration day In order to allow for transaction costs, no trading was undertaken in cases where Pg>0.97 Pr. An investor who buys shares and tenders does not incur transaction costs on the repurchase shares. Therefore, the transaction costs of this strategy are less than the costs of a round-trip transaction To test the sensitivity of the results to the timing of purchases and sales different trading rules were examined. The first trading rule assumes buying and ay and, if the offer is ascribed, selling the nonrepurchased shares two days after the expiration day. In the second trading rule, the purchase is made on the day before the expiration and the nonrepur chased shares are sold two days after the expiration. Finally, the third trading rule assumes that we buy on the day before the expiration day and sell four days after the expiration. In each case, results are provided for the total period and the two subperiods Note that the trading rule assumes that we can actually sell the shares two days after the expiration date. In general, a day after the offer expires, the company announces the outcome of the offer. If the offer is oversubscribed and the company decides not to buy all the shares, a preliminary pro-rata decision is announced. The preliminary pro-rata number is always very close to the final pro-rata allocation, which is announced within ten business days. However, an investor does not have to wait until the final pro-rata decision is made before lling the remaining shares Under the usual settlement procedure, an investor who buys shares will officially become the owner of the stock after five business days. Hence, buyin and tendering one day before the expiration day is not feasible. However, by following a cash-settlement procedure, it is possible to obtain title to the shares on the same day. Discussions with brokers revealed that cash settlement implies larger transaction costs for relatively small trades (i.e, a small investor cannot use discount brokers). Thus, we also tested the trading strategy by assuming that the stock was purchased six business days before the expiration day and the nonrepurchased shares are sold twelve business days after the expiration day The long post-expiration period reflects the fact that the exact pro-rata decision is known within twelve business days. B. Results The results of the trading strategy are shown in Table Il. The abnormal returns presented are adjusted for the market movement based on the CRSP equally 10 Shares are, in general, kept in the depository under the age name and transferred to the the receipt of payment for the acquin tendered, the brokerage house makes a commitment to ha ndered shares available, Because the preliminary pro-rata decision is very close to the final allocation, the nonrepurchased shares are released by the brokerage house after the preliminary announcement

Anomalous Price Behavior Around Repurchase Tender offers 461 Table ll Abnormal returns from Buying and Tendering Abnormal returns(in percent)from trading rule around expiration. according to the ading rule, shares are bought T days prior to the expiration date wl market price is at least three percent below the tender offer price. In oversubscribed offers, shares not repurchased by the company are sold T2 days after the expiration Mean t-value Positive Panel A: Total sample(1962-1986)(109 observations) Trading rule #1 5.88 94.5 0,T2=2) Trading rule #2 9.46 7.76 552 972 T2=2) Trading rule #3 9.26 758 5.59 27 1,T2=4) Panel B: First subperiod (1962-1979)(63 observations) Trading rule #1 Trading rule 8.01 758 (T1=-1,T2=2) Trading rule #3 726 5.59 (T1=-1,T2=4) Panel C: Second subperiod(1980-1986)(46 observations Trading rule 100.0 Trading rule #2 100.0 Trading rule #3 11.39 4.44 95.5 (T1=-1,T2=4) weighted index. Because the holding period is short, the results are not sensitive to the assumption made about the process that generates returns.( See Brown and Warner(1985). )However, only expected nonrepurchased shares are affected by the market risk. As shown in Table I, the fraction of shares purchased relative to the shares tendered exceeds 80 percent, and therefore this strategy is less risky than the benchmark portfolio Panel A of the table (which covers the total sample period)shows that, in 109 of the 258 cases, the market price is at least three percent below the tender offer price before the expiration date. The trading rules generate a rather impressive abnormal return of more than nine percent on average(not annualized), with t statistics larger than 7.5. The median value is smaller(5.5 percent), and at least 93 percent of the abnormal returns are positive. There seems to be no substantial difference among the various trading rules. Panels B and C show similar results for the two subperiods. The difference in average abnormal returns over the two subperiods is not statistically significant, although the abnormal returns are higher in the second subperiod. The median abnormal returns are essentially the same across the two subperiods, around 5.5 percent. The persistence of abnormal returns is striking: for example, in the

second subperiod, for two out of the three trading rules, the abnormal returns are always positive. The trading rule was repeated for cases where the market price was at lea five percent below the tender offer price. The results(available from the authors show that, while the number of observations falls by approximately 30 percent the average and median abnormal returns from the trading strategy increase by about two percent relative to the results reported in Table II To test whether the results depend on the market price relative to the tender price, the following regression was run XRET:=a+ B(Pri-. i)/PB.i + eir where XRETi is the abnormal return from the trading strategy for case i. All 19 cases in which the pre-expiration price was below the tender offer price are included in the sample Table IlI presents the regression coefficients and R2 for the various trading rules. The degree of underpricing (relative to the tender offer price) explains more than 75 percent of the variability of the returns generated by the trading strategy, and the slope coefficients are highly significant (t> 23). The slope coefficient of 0.85 implies that buying shares before the expiration date whenever he market price is x percent below the tender price results in abnormal returns of. 85x percent. Thus, the performance of the trading rule can be enhanced by focusing on cases where the pre-expiration price is substantially below the tender price. Note that this result is anomalous: in an efficient market, a low Pb relative to Pr would simply imply that the market expects a low Pe and/or a large A closer examination of the regression results reveals four outlier observa tions. Hence, a nonparametric Spearman rank correlation test was performed. The rank correlation coefficients for the three trading rules are 0.687, 0.667, and 0.685, respectively, and are statistically significant In Table Iv results are presented for the trading strategy which assumes that stocks are purchased six trading days prior to the expiration of the offer if the market price is at least three percent below the tender offer price. The nonre purchased shares are sold twelve trading days after the expiration of the offer The average and median abnormal returns are somewhat smaller than their corresponding values in Table II but are still substantial. On average, abnormal returns exceed 5.5 percent in all periods and are positive in about 90 percent of the cases. The trading strategy was repeated for cases where the market price was at least five percent below the tender offer price. This strategy increased the abnormal returns by about two percent relative to the results in Table Iv In order to test the relationship between the degree of underpricing and trading abnormal returns, we run the regression in equation(2). The results are consistent with the findings in Table III: a=-002(t= 3.62), 8=0.86(t= 18.85), and R 1 Regression results for the 109 cases where the market price was at least three percent below the tender price are similar to those reported in Table IlL. 12 We reran the regressions without the four outliers. The R for the three regressions in Table IV re equal to 0.58. 0.51, and 0.47, respectively. In each case, the independent variable was highly gnificant (t> 12)and the regression coefficient was larger than. 54