Earnouts as Payment Currency and Value Gains to Bidder Shareholders.

Contents

List of Tables

List of Abbreviations

List of Appendices

Abstrac

1. Introduction

2. Literature Review
2.1. Problems in Mergers and Acquisitions
2.1.1. Adverse Selection and Moral Hazard
2.1.2. Company Specifics
2.2. Implications for the Method of Payment
2.2.1. Stock and Cash
2.2.2. Earnout
2.3. Empirical Evidence
2.3.1. Cash and Stock
2.3.2. Earnout

3. Hypothesis Development

4. Data and Methodology
4.1. Data Collection
4.2. Sample Description
4.3. Methodology

5. Results
5.1. Univariate Analysis
5.2. Multivariate Analysis
5.3. Limitations and Areas of Further Research

6. Conclusion

Appendix

Bibliography

List of Tables

Table 1: Annual Distribution Sweden and Germany

Table 2: Summary Statistics Sweden and Germany

Table 3: Summary Statistics Earnout Sweden and Germany

Table 4: Definition of Variables

Table 5: Univariate Analysis Sweden and Germany

Table 6: Multivariate Regression Overall Sample Sweden and Germany

Table 7: Multivariate Regression Earnout Sample Sweden and Germany

List of Abbreviations

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List of Appendices

Appendix 1: Annual Distribution Sweden

Appendix 2: Annual Distribution Germany

Appendix 3: Multivariate Regression Earnout Sample Sweden/ Germany

Appendix 4: Multivariate Regression Overall Sample Sweden

Appendix 5: Multivariate Regression Overall Sample Germany

Abstract

This dissertation analyses the cumulative abnormal return (CAR) to Swedish and German bidders and the impact of method of payment. Cash and Stock as means of financing have been discussed widely in the last decades. More recently the contingent payment form earnout has come to focus of research which will be further investigated in this dissertation. The study involves a sample of 927 transactions of which 346 bids are made by German and 581 bids are made by Swedish acquirers. Moreover, the sample compromises 24 German and 49 Swedish earnout deals. The sample period is chosen from 01/01/1986 to 31/12/2012 whereby a German or Swedish company acquires a domestic or foreign target of any listing status. The univariate analysis shows marginally significant results for the outperformance of earnout over non-earnout in cross industry acquisitions (CIAs) and insignificant results for a combination of cash and earnout over cash-only. Furthermore, it provides evidence that earnout deals with a small relative earnout value (REAV) and a short earnout length (EAL) significantly outperform earnout deals with a large REAV and a long EAL. In addition, a multivariate regression is performed to control for the impact of several factors that previously have been found to determine bidder CAR. In conformity with existing studies of the UK and US takeover market, the multivariate analysis provides evidence that earnout currency is a mean to mitigate valuation risk and offers higher value gains to bidder shareholders than non-earnout currency. It further shows that a combination of cash and earnout is a superior means of financing than cash-only payments. Besides, the multivariate analysis supports the univariate results with respect to REAV and EAL and it is shown that earnout measures (EAMs) as profit and sales are important value determinants, which both offer positive and significant value gains to bidder shareholders in earnout deals.

1. Introduction

Mergers and Acquisitions (M&A) have become an important form of corporate development in the last 30 years (Cartwright and Schoenberg (2006)). Despite of mixed findings on their success, the number of announcements has not decreased, but increased, and are approximately 44,200 takeover announcements globally in the year 2012.^[1]

This is why a broad literature has developed on M&A and among others, the field of value creation has become of considerable interest (Datta et al. (1992)). The impact of the method of payment as a determinant of bidder shareholder wealth has been focused upon by many researchers and various studies discussing the different signaling effects and wealth impacts of cash and stock as means of financing (Myers and Majluf (1984); Roll (1986); Fishman (1989); Servaes (1991)). Overall, the existing research provides evidence that the use of cash currency creates a positive value for bidder shareholders whereas the use of stock leads to a loss of wealth (Travlos (1987); Amihud et al. (1990); Martin (1996b); Huang and Walking (1987)). However, different results for bidder value gains from cash and stock financing are found when target listing status is taken into account. The method of payment may reduce information asymmetries, or it might have monitoring effects and therefore influence bidder value gains (Chang (1998)).

More recently, a new method of payment has come into focus, namely the earnout currency. The particularity of earnouts lies in a deferred-performance based payment to the target. It allows overcoming valuation gaps between both bidder and target by transferring risk from the former to the latter (Frankel (2005)). Among the first to study earnout deals in the US market are Kohers and Ang (2000). These authors provide evidence that earnouts can be used as a risk reduction mechanism against mis-valuation when high asymmetric information is present. In addition, a study on the US M&A market by Cain et al. (2011) discusses the form of earnout contracts more detailed. It suggests that the determinants of contract terms are structured to minimise the costs of valuation uncertainty and moral hazard in acquisition negotiations. Moreover, this study finds that earnout contracts are considerably heterogeneous in potential size, length and performance measures on which contingent payments are based. Barbopoulos and Sudarsanam (2012) extend the research by analysing UK bidders. Since a larger proportion of UK targets compared to US targets exhibit a private listing status, valuation risk is especially high. The UK data support the existing US studies and the theory that earnout contracts are a mean to mitigate risk in situations of information asymmetry. Most recently, Kohli and Mann (2013) are the first to explore earnout deals in the emerging market by performing a similar study for India focusing on cross border acquisitions (CBAs). These authors report that cross border earnout deals offer value gains that are superior to those of cash offers; however, earnout deals appear to be inferior to stock-only deals. This is contrary to an earlier study by Mantecon (2009) that concludes that bidders do not benefit from earnouts in CBAs.

So far the literature on earnouts as a mean of financing is based mainly on US and UK data and discussions about the use and impact of earnout on bidder shareholder wealth are still highly topical and ongoing (Kohers and Ang (2000); Cain et al. (2011); Barbopoulos and Sudarsanam (2012); Datar et al. (2001); Reuer et al. (2003)). Therefore, the aim of this dissertation is to extend the existing research cited above for Europe, more precisely for the combined Swedish and German M&A markets which have not been explored. Similar to the UK a large part, i.e. approximately 75% of all deals concern unlisted, i.e. private and subsidiary targets and thus, valuation risk for Swedish and German acquirers is likely to be of a similar order of magnitude and significance as in the UK. Furthermore, both Sweden and Germany are chosen as acquirer countries and pooled because of the relatively high occurrence of earnout financing and to allow drawing significant conclusions. Besides, both Germany and Sweden are civil-law countries whose legal systems resemble one another and make legitimate the country pooling. Furthermore, this dissertation does not only expand on existing research geographically, but it also examines the impact of earnout components on bidder shareholder value creation, i.e. REAV, EAL and earnout measure (EAM). The impact of these factors on bidder shareholders announcement period gains has not been analysed in detail before.

The thesis is structured as follows. Chapter 2 gives an overview in the form of a literature review about existing research on value determinants in M&A. This forms the basis for the subsequent analysis in chapter 3 where the research purpose is stated and hypotheses are constructed regarding the effects of earnout deals as value determinants in M&A. In chapter 4 the sample and the methodology, which is used to analyse and interpret the data are described. Based on this discussion, a univariate and a multivariate analysis are performed. Results and limitations of this dissertation are presented in chapter 5. Finally, chapter 6 provides a conclusion on overall findings. The results of the univariate and multivariate analysis confirm that earnout deals outperform non-earnout transactions in CIAs. Moreover, the multivariate analysis indicates that a combination of cash and earnout offers value gains that are superior to those of cash-only financed deals. Furthermore, both univariate and multivariate analysis lead to the conclusion that a higher bidder announcement period value is created in mergers with a short EAL and a small REAV.

2. Literature Review

2.1. Problems in Mergers and Acquisitions

2.1.1. Adverse Selection and Moral Hazard

In the past a broad literature on M&A has evolved studying their occurrence and implications for wealth creation. M&A are found to take place when there is a potential gain from combining two companies due to synergies, and they typically are carried out to increase shareholder wealth (Jensen and Ruback (1983); Tuch and O'Sullivan (2007)). However, a significant part of mergers fall through or later turn out to be failures, which destroy shareholder wealth (Bruner (2002); Reuer (2005)). This may result from several problems arising in M&A.

Firstly, acquirers face the problem of adverse selection. Targets may have private information about their true value and difficulties in conveying it to the bidder.^[2] Due to such information asymmetries offers by the acquirer will reflect the possible mis-presentation by the target and the acquirer will demand for a discount (Myers and Majluf (1984)). This may lead to deals falling through and high quality firms being withheld from the acquirer (Reuer and Shen (2003); Akerlof (1970)). Moreover, for those deals that take place the bidder faces the risk of overpayment and picking a “lemon” (Reuer (2005)).

Secondly, even if the target valuation is correct and the problem of adverse selection can be eliminated the acquiring company cannot be certain about the future performance of the target. Therefore it is important to keep target managers in the company after the acquisition (Cain et al. (2011)). Their knowledge and skills are essential for the target’s future development, especially in industries relying on human capital and intangible assets.^[3] Thus, not succeeding to retain key management may result in a poor post-merger performance (Ranft and Lord (2000)). However, this further leads to the risk of moral hazard for the acquirer. In this case the term moral hazard describes the fact that even if target managers stay in the company after the takeover they may lack the incentive to generate the promised synergies after receiving the acquisition premium (Cain et al. (2011); Hölmstrom (1979)).

2.1.2. Company Specifics

Several company characteristics may influence the severity of information asymmetry, uncertainty and along with it the risk of overpayment of the bidder. Previous studies have identified such target specifics in which target valuation may be problematic. Firstly, the listing status of the target plays an important role. Large listed companies are usually better known and more information is available about them than for private companies (Caprona and Shen (2007)). Private companies and subsidiaries in general have to disclose less or no information compared to publicly listed companies resulting in situations with large information asymmetries (Kohers and Ang (2000); Draper and Paudyal (2006)). Moreover, public companies are more likely to offer information to investors voluntarily as greater levels of disclosure can reduce their cost of equity (Botosan (2000)). A further important factor of uncertainty in the acquisition of private targets is the lack of a daily stock market price and a market valuation of its assets. Thus, it is more difficult for private companies to signal their value to bidders and the lack of a benchmark makes it difficult for the bidder to establish a first target evaluation (Datar et al. (2001); Becchetti and Trovato (2002)).

Secondly, target uncertainty is very high when target companies possess many intangible assets (Kohers and Ang (2000); Barbopoulos and Sudarsanam (2012); Reuer et al. (2003)). Resources are difficult to evaluate by the bidder since future performance does not depend on assets in place, but on future growth opportunities and staff employed, e.g. when targets are operating in the high technology (HT) or the service industry (Harris and Ravencraft (1991); Reuer et al. (2003); Coff (1999); Myers (2000); Smith Jr. and Watts (1992)). A further problem for the valuation of intangible assets exists in the lack of an adequate reflection in a codified form such as a financial statement (Kohli and Mann (2013); Reuer et al. (2003); Harris and Ravencraft (1991); Kogut and Zander (1992)). Moreover, Lev and Zarowin (1999) show that the current accounting techniques for intangible assets fail to reflect a company’s real value mainly due to the mismatching of costs with revenues. For these reasons not only the bidder but also the target may face problems in resource valuation and may tend to produce an overconfident and overvalued result (Reuer (2005); Graebner et al. (2010)). Furthermore, in acquisitions of companies heavily relying on knowledge and intangible assets it is very important to retain target’s management. If a manager possesses specialised knowledge, the bidding company will face the risk of suffering large costs due to loss of knowledge and experience (Ranft and Lord (2000)).

Thirdly, the relatedness of bidder and target industry influence the degree of information asymmetry and value creation. Relatedness describes the extent to which bidder and target companies draw on similar forms of expertise (Coff (1999)). A bidder which is operating in the target industry can be expected to have a profound understanding of the target as well as similar business practices and organisational structures (Reuer et al. (2003); Flanagan and O'Shaughnessy (2003)). Alternatively, it can be argued that bidders may gain from diversifying acquisitions by reducing cash flow volatility of the combined firm and therefore create a higher value than acquisitions of related targets (Barbopoulos and Sudarsanam (2012); Sudarsanam (2010)).

Furthermore, the target’s domicile as a value determinant has been identified in previous research. Cross border deals involve a higher information asymmetry than domestic acquisitions due to information problems about the foreign market, accounting obligations, different cultures and languages (Mantecon (2009); Dutta et al. (2013)). In addition, there may be differences in organisational and managerial standards complicating the acquisition (Datar et al. (2001)).

Furthermore, firm size and age have been found to influence announcement period abnormal returns to bidders. Higher complexity of large firms may make resource valuation more difficult than in smaller firms (Alexandris et al (2013)). Moreover, Demsetz and Lehn (19885) state that management incentives in large companies may not be as aligned as they are in smaller companies and managers of larger companies thus might be overbearing in their resource evaluation (Demsetz, Lehn (1985)).^[4]

2.2. Implications for the Method of Payment

In efficient capital markets with certainty and no asymmetric information the method of payment in acquisitions should not matter because there would be no differences in terms of bidder or target shareholder wealth (Sudarsanam and Mahate (2003); Kohli and Mann (2013)). However, in practice the payment currency employed plays an important role in determining bidder and target shareholder wealth and preventing deal failure by helping to overcome the problems discussed in chapter 2.1.1. and 2.1.2. (Finnerty et al. (2012); Ismail and Krause (2010)).

2.2.1. Stock and Cash

Cash payments in M&A offer several advantages for both target and bidder. Firstly, the value of cash does not depend on the future performance of the target or other future unknown measures, and cash payments resolve the uncertainty problem about the bidder (Barbopoulos and Sudarsanam (2012)). Secondly, cash is applied as an instrument of target management to exit out of the company when no further involvement in the business is desired. However, the target company has to deal with the cost of not being able to participate in any post-merger synergy gains which have not been taken account of in the cash payment agreed upon. On the bidding side cash can be interpreted as a signal for proper or high valued shares of the bidder according to Myers and Majluf (1984) and Eckbo et al. (1990). When a bidding company is uncertain about the target value, however, it will avoid cash payments in order to prevent overpayment (Eckbo et al. (1990)). Furthermore, cash is used as financing mean in order to preempt other firms from bidding (Fishman (1989)).

In order to solve the problem of uncertainty and information asymmetry, firms can make use of contingent payment currencies, i.e. the use of stock or earnout (Barbopoulos and Sudarsanam (2012); Hansen (1987)).^[5] Contingent payments incorporate a risk sharing of bidder and target with respect to overpayment (Kohli and Mann (2013); Fuller et al. (2002)). Stock is the most commonly known form of contingent payment allowing the resolve one-sided information asymmetry (Finnerty et al. (2012); Reuer et al. (2003)). The value of a stock offer depends on the cash flows of the combined firm and thus, it also depends on the intrinsic value of the two separate companies (Chemmanur et al. (2009)). Moreover, when a stock payment is used, target shareholders remain shareholders in the merged company. This is why the use of stock reduces the valuation problem for the acquirer and forces the target to carry part of the risk (Barbopoulos and Sudarsanam (2012)). Moreover, Myers and Majluf (1984) argue that bidders will finance takeovers with stock if the board believes that its own shares are overvalued. Stock then allows converting overvalued equity into real assets. Eckbo et al. (1990) therefore claim that stock payments signal an overvaluation of equity. This can lead to a negative signaling effect, i.e. target shareholders do not accept stock offers assuming overvaluation of bidder’s stock or they demand a high premium in order to accept such a bid (Barbopoulos and Sudarsanam (2012); Shleifer and Vishny (2003)). Therefore, the positive effect of reducing uncertainty about the target might be abrogated by negative signaling costs. However, in cases of high uncertainty the costs of adverse signals can be exceeded by the benefits of mitigating the effects of information asymmetry. Thus, the use of stock still can be advantageous in some cases (Reuer et al. (2003)).

2.2.2. Earnout

Earnout currency is another form of contingent payment. Acquisition payments involving earnouts consist of a two component payment to target shareholders. Firstly, there is an upfront fixed payment and secondly, additional future payments that are conditional on some performance measure (Cain et al. (2011)). The latter component is commonly known as earnout (Barbopoulos and Sudarsanam (2012)). Bruner and Stiegler (2001) state that the upfront payment is equal to the value on which both bidder and target agree on and the second payment reflect the degree of valuation differences of the two parties. Moreover, earnouts can also be regarded as similar to a call option on the fair value of the target company (Caselli et al. (2006)).

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^[1] The number of deals bids is provided by Thomson Reuters M&A Security Database (SDC).

^[2] Additionally, problems such as time pressure, deal complexity or unfamiliarity with products and geographic location might be present which will be discussed in the following section.

^[3] A more detailed discussion of industries relying on intangible assets follows in chapter 2.1.2.

^[4] For further discussion on size as value determinant see Moeller et al. (2004)

^[5] Contingent Value Rights (CVR) are a further form of contingent payment, but are not subject of this study. For a detailed discussion see Chatterjee and Yan (2008).