Acquisitions are important corporate events that are often viewed as value destroying. The average returns to bidder firms that acquire other public corporations are negative around merger announcements, while average returns to target firms are positive. This finding has been interpreted as evidence of empire building, CEOs pursuing a personal agenda or CEOs’ overconfidence.¹ Why do acquirer shareholders not stand up and fight against value-destroying acquisitions?² Matvos and Ostrovsky (2008) (MO) provided a potential explanation to this puzzle by examining target ownership: since the acquirer’s institutional investors may hold shares in the target, the increase in value of the target may offset the losses on the acquirer side. This explanation was contested by Harford et al. (2011) (HJL), who argued that cross-ownership at the shareholder level was not large enough to compensate the acquirer shareholders in value-reducing acquisitions.

In this paper we aim to shed new light on this puzzle by considering the role of ownership in non-merging industry rival firms by acquirer shareholders. While the debate so far has focused on the wealth effects of the acquiring and target firms³, mergers generally have effects beyond them, impacting other rivals in the industry that are not involved directly in the acquisition. Extensive empirical evidence documents that, on average, there is a positive effect of takeover announcements on rival firm stock returns (Eckbo, 1983, Eckbo, 1985, Mitchell, Mulherin, 1996, Song, Walkling, 2000, Shahrur, 2005, Servaes, Tamayo, 2013). In addition, there is substantial ownership by acquiring shareholders in rival firms. As we will see, taking this ownership into account helps understand M&A decisions and the voting behaviour of acquirer shareholders.

When an acquirer firm conducts a horizontal merger, its non-merging industry rivals may gain for different reasons. There is a rich literature documenting the existence of both informational and real effects of merger announcements on rivals. Informational effects are changes in the valuation of rivals due to new information being revealed in the market without any change in the underlying fundamentals nor corporate policies of the firms. For example, rivals may gain because the merger increases the perceived probability that they could also become targets in the future (Song and Walkling, 2000), regardless of the form and outcome of the merger, or a reassessment of valuation of the firms in the sector.

Mergers also have real effects on rivals: rivals may gain due to improved efficiency at the expense of the merging firms (Eckbo, 1983, Shahrur, 2005, Clougherty, Duso, 2009, Bernile, Lyandres, 2019), increased market power due to a reduced number of industry participants (Eckbo, 1983, Eckbo, 1985, Sapienza, 2002, Fathollahi, Harford, Klasa, 2021), and more efficient corporate policies due to increased takeover threats in the industry (Servaes and Tamayo, 2013).⁴ Overall, these papers highlight the importance of real effects in explaining rivals’ stock price reactions to M&A horizontal deals.

We argue that diversified acquirer shareholders, holding broad portfolios of industry firms, can internalize not only target gains, but also gains in non-merging rival firms. This may lead to lower incentives to oppose deals with negative acquirer returns. In fact, many acquirer shareholders end up gaining from the merger, even when they lose from their position in the acquirer, supporting this internalization hypothesis.

Consider the following example: when Microsoft announced the $26.2 billion acquisition of LinkedIn in June 2016, the deal was perceived as value-destroying by the market and led to a loss of 1.46% for Microsoft shareholders in the 3-day window around the announcement. With a market capitalization of over $400 billion at the time, the losses for Microsoft’s largest shareholders were substantial, ranging from $72 million to $373 million, as shown in Fig. 1. Nine of these top ten shareholders also owned shares in the target. While LinkedIn did enjoy a large announcement gain of 45.97%, only two acquirer shareholders were able to offset its loss on Microsoft with a gain from LinkedIn.

However –and this is the main point of this paper– nine of Microsoft’s top ten institutional shareholders obtained a net gain thanks to the wealth effects from their ownership in rival firms. This was because, among Microsoft’s top twenty industry rivals, fifteen gained during the 3-day window around this announcement, and these gains were more than enough to compensate these shareholders for their losses from their holdings in Microsoft. Therefore, even though the deal may have seemed to be value-destroying, it actually created value for most of the top 10 shareholders of Microsoft.

In a sample of 1800 horizontal mergers among public firms from 1988 to 2016, we find that the pattern of acquirer holdings in non-merging rivals compensating for losses in the acquiring firm is fairly common. In particular, we show that the returns around deal announcement on rival stakes are on average positive –ranging from 0.14% to 0.28%, depending on the industry definition. Rival gains also continue beyond deal announcement with an average return of 0.84% from deal announcement to completion. The largest shareholders of the acquiring firm hold an average stake