Viewing Share Repurchases as a Market Signal - The Many Facets of Privately Negotiated Share Repurchases

Past research on greenmail finds hostile raiders are paid high premiums in privately negotiated share repurchases, leading to negative announcement returns. However, INSEAD's Schroders Chaired Professor of International Finance and Asset Management Theo Vermaelen, and Assistant Professor of Finance Urs Peyer challenge the interpretation that premiums are excessive, providing evidence that, on average, long-term shareholders receive a significant positive abnormal return consistent with the raider's premium following greenmail repurchases.

by Urs Peyer,Theo Vermaelen
Last Updated: 23 Jul 2013

Studies on share repurchases have traditionally yielded similar conclusions: capital structure benefits and signaling effects lead to stock price increases at the announcement of a repurchase. The exception was the firms which announced to buy back shares from hostile bidders, in so called greenmail repurchases, experienced a drop in the share price.

This price drop has been interpreted as evidence that managers act in their own interest when buying back shares from a hostile raider at a premium above the current market price. INSEAD's Schroders Chaired Professor of International Finance and Asset Management Theo Vermaelen and Assistant Professor of Finance Urs Peyer question this commonly accepted interpretation based upon the finding that over the two years after the greenmail repurchase, share prices significantly outperform.

In fact, long-term shareholders, on average, get a return that is about equal to the premium that was paid to the hostile raider. This seems consistent with the interpretation that managers use their inside information to repurchase shares. It is, however, unclear why the market initially reacts negatively to the announcement of a greenmail repurchase.

The authors contrast this with other types of privately negotiated share repurchases. Three additional categories were examined, differentiated by whether the repurchase price was at the market price, above (premium) or below (discount).

Connections between price of shares during repurchases and circumstance-based motivations were observed for each category. When companies repurchased shares at the market price, this was usually explained by insider activity, where for example stock options are exercised and executives sell the received shares back to the company directly, rather than via open market operations.

Other situations, where shares are repurchased at a premium or discount to market value, described the majority of transactions evaluated by this study. The amount of premium or discount was determined by the relative bargaining power of buyer and seller. Four factors influenced this balance of power: the first factor, liquidity, reduces the seller's bargaining power. While a private seller has the option to walk away and sell shares in the open market, this may be difficult if the stock is thinly traded, or if transaction size is large relative to average trading volume.

The second factor involves an inverse relationship between purchase price and growth opportunities of the buyer. Repurchasing shares could force a high-growth company to delay or forgo alternate investment opportunities, limiting likelihood of repurchase unless the price was perceived as a bargain. Third, financial constraints also limit a company's stock repurchases unless it occurs at a discount.

This effect is even more pronounced when the buyer is financially distressed, as the increase in leverage resulting from the transaction would cause further financial distress, provided funding is available at all. Conversely, if the seller is suffering financial constraints, they may be willing to sell at a discount in order to raise funds quickly. Finally, degree of management ownership in the buyer company was found to impact price as an increased personal stake in the deal outcome led to negotiations for a lower repurchase price.

Strength of effects on price movements differed by category. Only premium purchases were found to act as signals of share price increases at the announcement, while discounted purchases and other transactions provided no signaling information, acting as mere wealth transfers between the corporation and selling shareholders. Extending analysis to track stock returns for two years following the announcement window, premium and discounted repurchases were both found to display positive long-run abnormal returns.

Repurchases at market value were not associated with significant long-run abnormal returns, supporting the view that these reflect internal employees cashing out stock options. Interestingly, sellers of shares, if publicly traded, display a significant negative long-run abnormal return - but only if they sold their shares at a discount to the market price. This further supports the notion that managers of firms can potentially repurchase shares from distressed owners at a bargain price thus creating value for their own shareholders.

Journal of Financial Economics, February 2005

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