Earnouts as Payment Currency and Value Gains to Bidder Shareholders
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Textbook
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Summary
This study 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, and will be further investigated in this study. 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.
Excerpt
Table Of Contents
8
List of Abbreviations
Firm i's abnormal return
AR
Annual
report
CAR
Cumulative
abnormal
return
CBA
Cross border acquisition
CIA
Cross
industry
acquisition
DS
Datastream
DV
Deal
value
Euro
Firm i's error term
Firm i's expected return on day t
EAV
Earnout
value
EAL
Earnout
length
EAM
Earnout measure
Eq.
Equation
HT
High
technology
MTBV Market-to-book-value
M&A
Mergers and acquisitions
Mio
Million
MV
Market
value
Nexis
Nexis database
9
OLS
Ordinary
least
squares
Priv
Private
Firm i's return on day t
Market return on day t
REAV
Relative earnout value
RS
Relative
size
SDC
Security data Corporation
Tele
Telecommunications
$ United
States
Dollar
10
List of Appendices
Appendix 1: Annual Distribution Sweden ... 57
Appendix 2: Annual Distribution Germany ... 58
Appendix 3: Multivariate Regression Earnout Sample Sweden/ Germany ... 59
Appendix 4: Multivariate Regression Overall Sample Sweden ... 60
Appendix 5: Multivariate Regression Overall Sample Germany ... 61
11
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 contin-
gent payment form earnout has come to focus of research which will be further in-
vestigated 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 Swe-
dish company acquires a domestic or foreign target of any listing status. The univari-
ate 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 con-
formity 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 financ-
ing than cash-only payments. Besides, the multivariate analysis supports the univari-
ate 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 posi-
tive and significant value gains to bidder shareholders in earnout deals.
12
13
1.
Introduction
Mergers and Acquisitions (M&A) have become an important form of corporate de-
velopment in the last 30 years (Cartwright and Schoenberg (2006)). Despite of mixed
findings on their success, the number of announcements has not decreased, but in-
creased, 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 sig-
naling effects and wealth impacts of cash and stock as means of financing (Myers
and Majluf (1984); Roll (1986); Fishman (1989); Servaes (1991)). Overall, the exist-
ing 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)). Howev-
er, 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 pro-
1
The number of deals bids is provided by Thomson Reuters M&A Security Database (SDC).
14
vide 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 mini-
mise 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 exist-
ing 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 mar-
kets which have not been explored. Similar to the UK a large part, i.e. approximately
15
75% of all deals concern unlisted, i.e. private and subsidiary targets and thus, valua-
tion risk for Swedish and German acquirers is likely to be of a similar order of mag-
nitude 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 Ger-
many 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 an-
nouncement 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 lit-
erature 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 deter-
minants 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 find-
ings. The results of the univariate and multivariate analysis confirm that earnout
deals outperform non-earnout transactions in CIAs. Moreover, the multivariate anal-
ysis indicates that a combination of cash and earnout offers value gains that are supe-
rior to those of cash-only financed deals. Furthermore, both univariate and multivari-
ate analysis lead to the conclusion that a higher bidder announcement period value is
created in mergers with a short EAL and a small REAV.
16
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 poten-
tial gain from combining two companies due to synergies, and they typically are car-
ried out to increase shareholder wealth (Jensen and Ruback (1983); Tuch and O'Sul-
livan (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 perfor-
mance 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
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.
17
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 de-
scribes 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 asym-
metry, 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 prob-
lematic. 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 sub-
sidiaries 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 uncertain-
ty 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 sig-
nal their value to bidders and the lack of a benchmark makes it difficult for the bid-
der to establish a first target evaluation (Datar et al. (2001); Becchetti and Trovato
(2002)).
3
A more detailed discussion of industries relying on intangible assets follows in chapter 2.1.2.
18
Secondly, target uncertainty is very high when target companies possess many intan-
gible 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 em-
ployed, 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 intangi-
ble assets exists in the lack of an adequate reflection in a codified form such as a fi-
nancial statement (Kohli and Mann (2013); Reuer et al. (2003); Harris and Raven-
craft (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 infor-
mation asymmetry and value creation. Relatedness describes the extent to which bid-
der 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 under-
standing of the target as well as similar business practices and organisational struc-
tures (Reuer et al. (2003); Flanagan and O'Shaughnessy (2003)). Alternatively, it can
19
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 pre-
vious research. Cross border deals involve a higher information asymmetry than do-
mestic acquisitions due to information problems about the foreign market, account-
ing 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)).
4
For further discussion on size as value determinant see Moeller et al. (2004)
20
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 in-
volvement 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 (Bar-
bopoulos and Sudarsanam (2012); Hansen (1987)).
5
Contingent payments incorpo-
rate 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,
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).
21
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 over-
valuation of equity. This can lead to a negative signaling effect, i.e. target sharehold-
ers do not accept stock offers assuming overvaluation of bidder's stock or they de-
mand a high premium in order to accept such a bid (Barbopoulos and Sudarsanam
(2012); Shleifer and Vishny (2003)). Therefore, the positive effect of reducing uncer-
tainty 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 in-
volving 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)).
