Earnouts: The real value of disagreement in mergers and acquisitions

Earnout agreements link part of the payment for an acquired company to its future performance. Despite their option-like features, they cannot be valued using vanilla option-pricing methods. Two peculiar sources of risk affect these contracts: Bidder default before the earnout expiration (default risk) and potential litigation associated with earnouts (litigation risk). We developed an option-pricing model that encompasses these sources of risk, showing that counterparty and litigation risk can have a remarkable impact on earnout values. Our model's relevance is further enhanced by recent accounting standards that require contingent payments to be valued at fair value.     

The value of control: Evidence from full and partial acquisitions in the real estate industry

We investigate the differential wealth effects of (1) full and partial control acquisitions, (2) nonreal estate, real estate and REIT participants, and (3) single- and multiple-bidder events. We find that target firms earn positive excess returns at the announcement of partial and full acquisitions, but acquisitions that result in control earn larger excess returns than noncontrol acquisitions. An examination of industry differences shows that real estate firms or REITs do not earn higher returns relative to nonreal estate firms. Our analysis of market structure finds that bidders that are not involved in an acquisition program earn greater announcement period returns than prior acquirers. For target firms, we find that those with a single offer earn higher returns than those with subsequent offers. A cross-sectional regression analysis shows that while market structure is important in explaining returns, the main determining factor for target firms is the degree of control sought.     

Making the deal real: how GE Capital integrates acquisitions

Most companies view acquisitions and mergers as onetime events managed with heroic effort--anxiety-producing experiences that often result in lost jobs, restructured responsibilities, derailed careers, and diminished power. Little wonder, then, that most managers think about how to get them over with--not how to do them better. But even as the number of mergers and acquisitions rises in the United States, studies show the performance of the resulting companies falls below industry averages more often than not. To improve these statistics, executives need to view acquisition integration as a manageable process, not a unique event. One company that has done exactly that is GE Capital Services, which has assimilated more than 100 acquisitions in the past five years alone and, in the process, has developed a formal model for melding new acquisitions into the corporate fold. Drawing on their experiences working with the company to develop the model, consultants Ron Ashkenas and Suzanne Francis, together with GE Capital's Lawrence DeMonaco, offer four lessons from the company's successful run. First, begin the integration process before the deal is signed. Second, dedicate a full-time individual to managing the integration process. Third, implement any necessary restructuring sooner rather than later. And fourth, integrate not only the business operations but also the corporate cultures. These guidelines won't erase all of the discomfort that accompanies many mergers, but they can make the process more transparent and predictable for those involved.     

The sources of value destruction in acquisitions by entrenched managers

Prior work has established that entrenched managers make value-decreasing acquisitions. In this study, we determine how they destroy that value. Overall, we find that value destruction by entrenched managers comes from a combination of factors. First, they disproportionately avoid private targets, which have been shown to be generally associated with value creation. Second, when they do buy private targets or public targets with blockholders, they tend not to use all-equity offers, which has the effect of avoiding the transfer of a valuable blockholder to the bidder. We further test whether entrenched managers simply overpay for good targets or choose targets with lower synergies. We find that while they overpay, they also choose low synergy targets in the first place, as shown by combined announcement returns and post-merger operating performance.     

Asset value management in the Portuguese real estate sector

This paper analyzes whether real estate investment fund managers use asset valuation discretion strategically to achieve financial reporting objectives. Portuguese real estate investment funds represent a unique opportunity to investigate executive behavior regarding accounting choice, as fund managers may choose to use historical cost, fair value or a mixed system (historical cost with internal revaluations) to value fund properties. We also investigate the factors that influence this strategic behavior. Empirical results confirm that fund managers manage asset valuations in order to avoid net asset value declines, particularly in a period of financial distress. We also observe that funds with a higher level of past unconditional conservatism are more likely to manage asset values. With respect to corporate governance issues, we conclude that audit quality reduces managerial discretion and that the conflicts that may arise between fund management company shareholders and fund participants due to management fees do not seem to have impact on fund managers’ opportunistic behavior.     

The value of risk in real estate markets

In this article we test the urban asset pricing model of Capozza and Sick (1988) and focus on the empirical dimensions of the effects of risk on urban land prices. The effects of systematic and unsystematic risk are distinguished in the model which incorporates the value of the option to convert land to urban uses into the pricing of urban real estate. We find the value of systematic risk in our Canadian urban areas to be negative and highly statistically significant. We find that approximately 2.5 percent of the value of houses in our sample arises from systematic risk. In our sample, unsystematic risk is a larger proportion of total risk than systematic risk. Therefore, most of the effect of total risk may be ascribed to unsystematic risk. The effect of total risk on land prices is illustrated through the irreversibility premia estimates. These premia vary greatly in size and statistical significance. Thus, the effect of unsystematic risk is highly city specific. In the two regions where the irreversibility premia are statistically significant, it accounts for 22 percent and 53 percent of the average housing price; thus, unsystematic risk can be a very important determinant of housing prices.These results highlight the importance of risk in determining urban land prices. The value of the option to convert land to urban uses imparts considerable value to developed land and must be considered when evaluating interurban area price differences.     

Return predictability and the real option value of segments

Theory suggests that firm value should include the value of real options; that is, firms have the option to expand more profitable businesses and liquidate less profitable businesses. In a diversified firm, each segment has its own real options. Applying real options theory to a diversified firm at the firm level neglects the value of segment-level options. If investors overlook segment-level options, mispricing will occur. Using data from 1981 to 2013, we find that a hedge portfolio buying diversified firms in the highest decile of the estimated real option value of segments (RVS) and selling those in the lowest RVS decile earns a significant 0.79% size-adjusted monthly return. The hedge returns are more significant for firms whose growth opportunities mainly lie in the more profitable segments. We also find that the predictive power of RVS is stronger for firms with high growth, lower analyst coverage, and stronger corporate governance. Further investigation links improved operating performance to the exercise of segment-level real options.     

Euphoria in financial markets: How Indian companies generate value in their cross-border acquisitions

In this paper, we investigate the effect of euphoria on returns derived by Indian companies in their cross-border acquisitions. Cognitive legitimacy generated at the country level facilitated firms in deriving higher value from internationalization. In addition, overoptimism after the legitimacy-building event led to euphoria in financial markets and short-term abnormal returns. Hence we argue that the springboard effect created by legitimacy is short-lived, as euphoria fades away over time. Using cross-border and domestic acquisitions by Indian companies during 1999–2009, and controlling for fundamental factors, both financial and non-financial, we find support for our euphoria hypothesis. Because of overoptimism, Indian companies experienced short-term abnormal returns in their cross-border acquisitions in the few years following the legitimation process, but not in later years.     

Real options give insights into real value

Developments in real options theory are resulting in valuation tools more suited to our increasingly dynamic economy. These tools can help where conventional business valuation techniques fail to capture the full opportunity value of new business strategies. Steve Leppard and Peter Morawitz report.     

从银行卡看信息技术真价值

作为本届金融展的重要组成部分,由中国人民银行牵头,工、农、中、建等发卡银行及中国邮储、中国银联股份有限公司共计18家机构联合主办的“金卡工程(银行卡)十年成就展”备受各界瞩目。展会不仅展示了各发卡单位十年来的业务发展历程,而且重点展示了“银行卡联网通用、联合发展     

Asymmetric-information and principal-agent problems as sources of value in FSLIC-Assisted acquisitions of insolvent thrifts

This study uses a two-factor market-model to estimate excess returns around 43 announcements of FSLIC-assisted thrift mergers and 66 announcements of unassisted thrift mergers. These estimated excess returns are then used to test hypotheses about asymetric-information and principal-agent problem in the thrift resolution process as sources of value in these mergers. The results show that acquirers in assisted transactions earned positive and statistically significant excess returns of approximately 2 percent, whereas acquirers in unassisted transactions earned excess returns that are not significantly different from zero; however, the excess returns in the assisted mergers are quantitatively small. For the 43 assisted mergers, estimated excess returns imply aggregate wealth transfers of only $13 million as compared with $2.3 billion in FSLIC assistance that were granted in these transactions. These findings suggest that the FSLIC-assisted transactions were reasonably well structured and that the assistance granted did not result in large wealth transfers to acquirers of insolvent institutions. Finally, the study provides evidence that informational asymmetries and principal-agent problems in the thrift resolution process were significant sources of excess returns for the acquirers receiving FSLIC assistance.The views reflected in this paper are those of the authors and do not necessarily represent policies of Board of Governors of the Federal Reserve System or the Federal Housing Finance Board. Helpful comments were recieved from participants in the Finance Workshop at the University of North Carolina at Chapel Hill, George Benston, Richard Brown, Jennifer Conrad, Sally Davies, Mark Flannery, Edward Kane, David Ravenscraft, and Lawrence J. White.     

The value of CEOs' supply chain experience: Evidence from mergers and acquisitions

Acquirer CEOs with experience in the target's industry supply chain (‘supply chain CEOs’) are associated with wealth effects of first-order importance: they earn 1.5% higher merger announcement returns. Conversely, their targets get a lower share of the merger gains. Acquisitions by supply chain CEOs also exhibit higher synergies, better post-deal accounting performance, and less goodwill written off. These findings withstand checks for endogeneity, anticipation bias, and numerous robustness tests. In takeovers by supply chain CEOs, superior acquirer performance stems from both value creation and rents negotiated away from target shareholders.     

Public disclosure in acquisitions

This paper analyzes firms’ optimal choice of information disclosure before an acquisition. The intuition is that value‐maximizing firms face the following tradeoffs. First, a more precise disclosure reduces risk premia. Second, too precise a disclosure that allows targets to profit increases the price paid for the target in an acquisition. The main conclusion is that firm chooses to disclose either all information or the minimum information required by the regulators, depending on the disclosure requirements, investors’ risk aversion, and the uncertainty embedded in technology shocks.     

Financial market integration and the value of global diversification: Evidence for US acquirers in cross-border mergers and acquisitions

In contrast to the previously documented cross-border discount, we find that there is positive cross-border effect for US acquirers during late 1990s and early 2000s. This is especially particular the case for those that acquire/merge with targets from segmented financial markets where acquirers experience significantly higher positive abnormal returns than those that acquire targets from integrated financial markets. Furthermore, firms acquiring segmented-market targets are also characterized by significantly higher post-merger operating performance improvement. The results indicate that the observed positive cross-border effect is mainly due to the increase in the number of transactions involving targets from segmented markets, in which the average firm experience significant financial constraints. We contend that value is created by a combination of firms with different financial market integration status, in which funds are provided to high cost firms. The finding that the value creation is even higher within the group of acquirers with a lower cost of capital provides additional support for our conjecture.     

Mitigating risks in cross-border acquisitions

Compared to domestic acquisitions, cross-border acquisitions present greater challenges for buyers. This article analyzes the use of contingent payments, joint ventures, and toehold investments as potential mechanisms for reducing uncertainty in cross-border acquisitions. Toehold investments and earnout payments are associated with larger gains to buyers in domestic acquisitions, but not in cross-border acquisitions. The results indicate that joint ventures can be an effective mechanism to ameliorate the uncertainty associated with cross-border acquisitions in the presence of severe valuation uncertainties and country investment risks.     

Skill differences in corporate acquisitions

Are there skill differences in mergers and acquisitions? To investigate this question, we focus on persistence in the performance of corporate acquirers. We find persistence only when successive deals occur under the same CEO and conclude that skill differences in acquisitions reside with the CEO, not with the firm as a whole. These differences are economically meaningful. An acquirer that was successful in its last deal and kept its CEO earns 1.02% more on its next deal than does a previously-unsuccessful firm that kept its CEO. This percentage difference is equivalent to a $175 million difference in value creation.     

Glamour versus value,market timing and firm performance: evidence from mergers and acquisitions

This study examines the performance of glamour versus value firms in M&As. Specifically, the current study takes into account the market timing to explore the performance of glamour versus value firms in M&As. Using the standard event study methodology with 1109 targets and 6980 bidders during the 2000–2013 period, the results show that glamour (value) firms are more likely to choose the hot (cold) market condition to engage in M&As for both targets and bidders. The evidence also reveals that the performance of glamour versus value firms is less sensitive to the market timing for targets. While glamour bidding firms obtain lower announcement returns, the losses are even more significant during long run post-announcement period. A further analysis indicates that bidders in general experience negative announcement returns in the hot market irrespective of glamour versus value firms. While glamour bidding firms obtain lower post-announcement returns in the hot market relative to their value counterparts, glamour bidders generate higher post-announcement returns during the cold market than value bidders. The regression analysis finds consistent results for bidders. Overall, this study sheds lights on the importance of the market timing on the performance of glamour versus value firms in M&As.     

The effects of anticipated future investments on firm value: evidence from mergers and acquisitions

I examine the long-term valuation consequence of investment in mergers and acquisitions on acquiring firms through the “anticipation effect,” in which forward-looking prices embed investors’ expectations about the profitability of firms’ future acquisitions. Using a sample of firms with past acquisitions, I find that their market valuations depend on both the profitability of their past acquisitions and their current free cash flow. Among firms with positive free cash flow (when future acquisitions are likely), those with a worse history of value-destroying acquisitions experience lower market valuations. Among firms with negative free cash flow (when future acquisitions are less likely), firm value is not systematically related to acquisition history. These findings are consistent with investors forming expectations about the profitability of future acquisitions based on realized acquisition outcomes and valuing these firms based on their likelihood of making future acquisitions. They also provide support for using observed market prices as a proxy for investors’ expectations about future investment opportunities.     

Unlocking value: Equity carve outs as strategic real options

Equity carve outs, the partial listing of a corporate subsidiary, appear to be transitory arrangements, usually dissolved within a few years by either a complete sale or a buy back. Why do firms perform expensive listings just to reverse them thereafter? We interpret carve outs of a production unit as strategic options to attract information from the market over its value as an independent entity. This improves the decision to exercise the option to sell out or to regain control. A listing is costly, as it reduces coordination of production, but generates valuable information from the market over the optimal allocation of ownership. We compute the optimal timing for the final sale or buy back decisions, the value of the strategic options embedded in the carve out and the optimal shares retained. The model explains the temporary nature of carve outs, and suggests an explanation for many empirical findings. In particular, it explains why carve outs are more common in highly uncertain sectors and in more informative markets.