Economic Determinants and Information Environment Effects of Earnouts: New Insights from SFAS 141(R)

Contingent considerations (earnouts) in acquisition agreements provide sellers with future payments conditional on meeting certain conditions. Prior research provides evidence that acquiring firms use earnouts to minimize agency costs associated with acquisitions. Using earnout fair value information, recently mandated by SFAS 141(R), we provide new insights into the economic determinants to include earnout provisions in acquisition agreements, including motivations to resolve moral hazard and adverse selection problems, bridge valuation gaps, and retain target firm managers. We document variations in initial earnout fair value estimates and earnout fair value adjustments that correspond with these underlying motivations. We also provide evidence that target managers stay longer with the firm after the acquisition when earnouts are included primarily to retain target managers. Finally, we demonstrate that earnout fair value adjustments required by SFAS 141(R) provide valuable information to market participants and are negatively associated with the likelihood of contemporaneous and future goodwill impairments.     

The effect of option listing on financing decisions

This paper investigates the effect of option listing on corporate financing decisions. Firms experience a significant drop in leverage, which is driven mainly by an increase in new equity issues. This effect is more prominent in firms with greater information asymmetry and lower percentages of quasi-index and transient investors before listing and those with active options trading after listing. After options are listed, the newly listed firms hold more cash and engage in more acquisitions, which are funded mainly by equity issues. These findings suggest that option listing has a significant impact on financing decisions because of lower information asymmetry and that firms use the post-listing equity to build up financial slack and support major investments, such as acquisitions.     

Access to private equity and real firm activity: Evidence from PIPEs

We study how access to private equity financing affects real firm activities using a broad panel of publicly traded U.S. firms that raise external equity through private placements (PIPEs) between 1995 and 2008. The public firms relying on PIPEs are generally small, high-tech firms that cannot finance investment internally and likely face severe external financing constraints; PIPEs are by far the most important source of finance for these firms. We show that firms use PIPE inflows to maintain extremely high R&D investment ratios and to build substantial cash reserves. We also use GMM techniques that control for firm-specific effects and the endogeneity of the decision to raise private equity and find that PIPE funding has a substantial impact on corporate investment in cash reserves and R&D, and a smaller but significant impact on investment in non-cash working capital, but little impact on fixed investment or acquisitions. Our estimates indicate that R&D investment initially increases by $0.20–$0.25 for each dollar of private equity flowing into the firm, and that PIPE funds initially invested in cash ultimately go to R&D. These findings offer direct evidence that access to private equity finance has an important effect on the key input that drives innovation at the firm- and economy-wide levels.     

Auditor monitoring and verification in financial contracts: evidence from earnouts and SFAS 141(R)

We study how monitoring and verification of accounting-based performance benchmarks influences the design and efficiency of earnout contracts. Earnouts are commonly used to resolve agency conflicts arising in mergers and acquisitions, but these contracts create measurement and other agency problems when contingent payments are tied to future accounting-based performance. Exploiting changes in auditor monitoring of earnouts that arose as\ a consequence of SFAS 141(R), we find that acquisition contracts are more likely to incorporate accounting-based earnouts and that contingent payments tied to accounting-based performance benchmarks make up a larger portion of the consideration when acquiring firms have high-quality auditors. We also find that market reactions to announcements of earnout deals are more positive after SFAS 141(R) for acquisitions most susceptible to disputes over accounting-based performance metrics and these results are more pronounced for acquiring firms with high-quality auditors. By exploiting the features of this unique setting, we illuminate the role of monitoring and verification of accounting information in financial contracts.     

Acquisitions: A curse or blessing for direct competitors? The impact of target ownership structure

This study examines the impact of horizontal acquisition announcements on the value of direct competitors of the combined entity. We argue that the ownership structure of the target drives competitor wealth effects. First, the stronger disciplining force of the market for corporate control for public firms compared to private firms will lead to higher competitive pressure post-acquisition when a public firm is acquired, leading to more negative valuation effects of direct competitors. Second, acquisitions of subsidiary targets, compared to stand-alone targets, are expected to lead to stronger asset utilization improvements in the target, leading to more negative competitor returns. A unique hand-collected sample of 1038 direct competitors of 228 horizontal acquisitions in Europe empirically supports these hypotheses. Alternative explanations, such as information asymmetry or empire-building, are rejected.     

What drives the valuation premium in IPOs versus acquisitions? An empirical analysis

Using a hand-collected data set of private firm acquisitions and IPOs, this paper develops the first empirical analysis in the literature of the “IPO valuation premium puzzle,” which refers to a situation where many private firms choose to be acquired rather than to go public at higher valuations. We also test several new hypotheses regarding a private firm's choice between IPOs and acquisitions. Our analysis of private firm valuations in IPOs and acquisitions indicates that IPO valuation premia disappear for larger VC backed firms after controlling for various observable factors affecting a firm's propensity to choose IPOs over acquisitions. Further, after controlling for the long-run component of the expected payoff to firm insiders from an IPO exit, we find that the IPO valuation premium vanishes even for larger non-VC backed firms and shrinks substantially for smaller firms as well. Our Heckman-style treatment effects regression analysis demonstrates that the above results are robust to controlling for the selection of exit mechanism by firm insiders based on unobservables. Our findings on private firms' choice between IPOs and acquisitions can be summarized as follows. First, firms operating in industries characterized by the absence of a dominant market player (and therefore more viable against product market competition) are more likely to go public rather than to be acquired. Second, more capital intensive firms, those operating in industries characterized by greater private benefits of control, and those which are harder to value by IPO market investors are more likely to go public rather than to be acquired. Third, the likelihood of an IPO over an acquisition is greater for venture backed firms and those characterized by higher pre-exit sales growth.     

The corporate choice between public debt,bank loans,traditional private debt placements,and 144A debt issues

The main purpose of this study is to examine the determinants of the corporate choice between different forms of debt financing. By analyzing the most comprehensive sample of US corporate debt issues to date, I find that firms that issue 144A debt have significantly lower credit quality and higher information asymmetry than firms that issue traditional non-bank private debt. Further, the study shows that traditional private placements, rather than bank loans, are the favorite private debt source for firms with good credit quality. I also show that the firm characteristics of traditional private debt issuers have significantly changed after 1990 through to 2003. My results suggest the following pecking order of debt choices which is conditional on credit quality. In other words, high credit quality firms prefer public bond offerings and small firms, with good credit quality, are more likely to issue traditional private debt. A large group of firms characterized by moderate credit quality make extensive use of bank loans and poor credit quality firms preferentially issue 144A debt.     

Does a change in the information environment affect labor adjustment costs?

We consider how a firm's information environment impacts an index of three proxies for the costs it incurs when adjusting its workforce. We show firms with less information asymmetry have lower labor adjustment costs (LACs). Moreover, this relation is stronger for firms with lower financing constraints and stronger financial performance and growth, which suggests these attributes are particularly appealing to employees. Our difference-in-difference tests based on two exogenous asymmetric information shocks around broker mergers and closures, and decimalization indicate the link is likely causal. Finally, we show that LACs are an important channel through which information asymmetry impacts firm value.     

Institutional arrangements and debt financing

I find that institutional arrangements have an impact on the real economy by affecting firms’ choice between private and public debt and the subsequent financing costs. Using new debt issued by firms in 26 non-US countries, I find, after controlling for firm characteristics predicted by debt agency and information asymmetry theories, that the level of financial market development, the efficiency of bankruptcy procedure, the integrity and enforceability of laws, and the transparency of financial information have significant impacts not only on firms’ debt choice and yield to maturity in domestic debt market, but also their issuance choice in the international debt market.     

Information Asymmetry and Corporate Investment Decisions: A Dynamic Approach

This paper develops a dynamic model of the financing and operating decisions of firms in the presence of information asymmetry. When the value of growth opportunities is not fully recognized, securities are undervalued, thus influencing the financing and investment decisions. The agency‐based underinvestment problem is re‐examined under information asymmetry. For firms with greater growth opportunities, the investment distortion resulting from information asymmetry is especially significant. Information asymmetry also increases the expected bankruptcy cost. The cost of information asymmetry in terms of both the firm value and the information spread under the optimal capital structure could be substantial.     

Do analysts follow emerging economy firms with higher intangible assets? Empirical evidence from Egypt

This paper tests whether analyst coverage and effort are related to the level of intangible assets reported by Egyptian listed firms. Intangible assets represent increasingly important investments for many firms, but most of these assets are not capitalized under prevailing accounting standards. Analysts reduce the information asymmetry by examining both financial reports and other information. Many Egyptian firms today seek access to foreign capital. I hypothesize that the larger the potential intangible assets of firms the more analysts will cover these firms and pursue private information about these firms. Sample consists of 435 firm-year observations over the period 1999–2007, and intangible assets are measured using eight different firm- and industry-level proxies. Consistent with prior research, results suggest that coverage is significantly associated with firm R&D, industry advertising expenses, firm size, and trading volume. Results also suggest that analyst effort is a function of firm and industry-level R&D expenses and firm size.     

Access to Capital, Capital Structure, and the Funding of the Firm

Based upon a large data set of public and private firms in the United Kingdom, I find that compared to their public counterparts, private firms rely almost exclusively on debt financing, have higher leverage ratios, and tend to avoid external capital markets, leading to a greater sensitivity of their capital structures to fluctuations in performance. I argue that these differences are due to private equity being more costly than public equity. I further examine the private firms subsample to show that private equity is more costly than its public counterpart due to information asymmetry and the desire to maintain control.     

Corporate Control and the Choice of Investment Financing: The Case of Corporate Acquisitions

We test the proposition that corporate control considerations motivate the means of investment financing—cash (and debt) or stock. Corporate insiders who value control will prefer financing investments by cash or debt rather than by issuing new stock which dilutes their holdings and increases the risk of losing control. Our empirical results support this hypothesis: in corporate acquisitions, the larger the managerial ownership fraction of the acquiring firm the more likely the use of cash financing. Also, the previously observed negative bidders' abnormal returns associated with stock financing are mainly in acquisitions made by firms with low managerial ownership.     

Do Acquisitions Relieve Target Firms’ Financial Constraints?

Managers often claim that target firms are financially constrained prior to being acquired and that these constraints are eased following the acquisition. Using a large sample of European acquisitions, we document that the level of cash that target firms hold, the sensitivity of cash to cash flow, and the sensitivity of investment to cash flow all decline, while investment increases following the acquisition. These effects are stronger in deals that are more likely to be associated with financing improvements. Our findings suggest that acquisitions relieve financial frictions in target firms, especially when the target firm is relatively small.     

Being private,Big 4 auditors,and debt raising

This study investigates the role of auditor choice (Big 4/Non-Big 4) in debt financing for private and public firms. We find private firms have less access to debt than public firms, and Big 4 auditors support debt raising in both private and public firms. Consistent with private firms facing greater information asymmetry, Big 4 auditors are more important for debt raising in private firms than in public firms. The benefit of appointing Big 4 auditors for private firms' debt raising is greater in the opaque information environment of the global financial crisis. It is also greater when firms are smaller, younger, or have poorer financial reporting quality. We also find evidence consistent with Big 4 auditors mitigating agency conflicts and enhancing debt raising when ownership concentration is higher in private firms.     

Corporate financing and anticipated credit rating changes

Firm circumstances change but rating agencies may not make timely revisions to their ratings, thereby increasing information asymmetry between firms and the market. We examine whether firms time the securities market before a credit rating agency publicly reveals its decision to change a firm’s credit rating. Using quarterly data, we show that firms adjust their financing structures before credit rating downgrades are publicly revealed. Specifically, firms on average increase their debt financing by 1.29 % before the disclosure of a rating downgrade, and this increase is due to the issuance of debt rather than the repurchase of equity. In contrast, firms do not take significant financing actions before credit rating upgrades.     

The liquidity and trading activity effects of acquisition payment methods: Evidence from the announcements of private firms' acquisitions

We investigate how the liquidity and trading activity effects of the announcement of the acquisition of private targets vary by payment method. We find significant increases in trading activity around acquisition announcement dates irrespective of the payment method used; however, fluctuations are lower for acquisitions financed by earnouts and cash. Similarly, the stocks of acquirers using cash and earnouts are also less affected by a general loss of liquidity that accompanies announcements. We show that these effects are explained by the interpretation of cash acquisition by the market as an option used when acquirers perceive no risk of being adversely selected, and the potential of earnout as an adverse selection risk reduction tool.     

Eat or Be Eaten: A Theory of Mergers and Firm Size

We propose a theory of mergers that combines managerial merger motives with an industry-level regime shift that may lead to value-increasing merger opportunities. Anticipation of these merger opportunities can lead to defensive acquisitions, where managers acquire other firms to avoid losing private benefits if their firms are acquired, or "positioning" acquisitions, where firms position themselves as more attractive takeover targets to earn takeover premia. The identity of acquirers and targets and the profitability of acquisitions depend on the distribution of firm sizes within an industry, among other factors. We find empirical support for some unique predictions of our theory.     

Information asymmetry,leverage and firm value: Do crisis and growth matter?

Drawing on pecking order and agency cost theories, we assess the extent to which information asymmetry is an important determinant of firm value and the extent to which this relationship is conditional on the leverage level of firms. We also assess the impact of information asymmetry on firm value during the pre and post 2007/09 financial crisis period and for high and low growth opportunity firms. Using a large sample of UK firms, our empirical findings suggest that information asymmetry adversely impacts firm value, and that this effect decreases with firm's leverage. We also find that leverage has a negative effect on firm value, and that the marginal effect of leverage is lower for information asymmetric firms. Further, we find that the relation between information asymmetry and firm value is more pronounced in the post-crisis period than the pre-crisis period. Finally, we show that the impact of information asymmetry on firm value is higher (lower) for firms with high (low) growth opportunities.     

Corporate investment and financing under asymmetric information

We develop a dynamic model of corporate investment and financing decisions in which corporate insiders have superior information about the firm's growth prospects. We show that firms with positive private information can credibly signal their type to outside investors using the timing of corporate actions and their debt-equity mix. Using this result, we show that asymmetric information induces firms with good prospects to speed up investment, leading to a significant erosion of the option value of waiting to invest. Additionally, we demonstrate that informational asymmetries may not translate into a financing hierarchy or pecking order over securities. Finally, we generate a rich set of testable implications relating firms’ investment and financing strategies, abnormal announcement returns, and external financing costs to a number of managerial, firm, and industry characteristics.