Incentive‐compatible contracts in merger negotiations: The role of acquirer idiosyncratic stock return volatility

• Date: 01 February 2020
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/fmii.12124
• Author: Dimitris Alexakis,Leonidas G. Barbopoulos

DOI: 10.1111/fmii.12124

ORIGINAL ARTICLE

Incentive-compatible contracts in merger

negotiations: The role of acquirer idiosyncratic

stock return volatility

Dimitris Alexakis1Leonidas G. Barbopoulos2

1Independent researcher

2University of Edinburgh, Business School

Correspondence

LeonidasG. Barbopoulos, University of

Edinburgh,Business School, 29 Buccleuch Place,

Edinburgh,EH8 9JS, UK.

Email:leonidas.barbopoulos@ed.ac.uk

Abstract

We show that the acquiring firm’s idiosyncratic stock return

volatility (sigma) is an important determinant of the selection and

perceived valuation effects of earnouts in Mergers and Acquisi-

tions (M&As). Earnout-based M&As are more often announced by

high-sigma acquirers (nearly 40% of all earnout-based M&As), yet

the documented higher risk-adjusted returns accrued to acquirers

in earnout-based M&As, relative to M&As settled in cash, stock or

mixed payments (the earnout effect), appear in deals announced

by low-sigma acquirers (nearly 20% of all earnout-based M&As).

High-sigma acquirers employing earnouts appear to break even, or

even experience losses, relative to their counterparts employing

single up-front payments. These results are confirmed based on

a quasi-experimental design through which the earnout effect

is measured in isolation. We argue that in M&As announced by

high-sigma acquirers, the earnout effect is potentially elusive due to

the presence of an acquirer-specific information revelation effect,

resulting from the heightened extent of information asymmetry

between (small) acquirers’ managers and outside investors. On the

contrary, the use of earnouts in M&As announced by low-sigma

(large) acquirers, whereby the acquirer-specific information revela-

tion effect is likely negligible, sends a strong signal for value creation

that also prevents investorsfrom inducing a size-related discount.

KEYWORDS

acquirer idiosyncratic stock return volatility (sigma), earnouts,

information asymmetry, propensity score matching (PSM),

risk-adjusted returns

JEL CLASSIFICATION

G12, G13, G14, G30, G34

c

2019 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

Financial Markets,Inst. & Inst. 2020;29:3–40. wileyonlinelibrary.com/journal/fmii 3

4ALEXAKIS ANDBARBOPOULOS

1INTRODUCTION

The choice of payment method in Mergers and Acquisitions (M&As) is often guided by the aim of mitigating valuation

risk, originating from asymmetric information (i.e. adverse selection) over the target firm (Eckbo, Giammarino, &

Heinkel, 1990; Eckbo, Makaew, & Thorburn, 2018; Faccio & Masulis, 2005; Hansen, 1987). Such adverse selection is

particularly prominent in M&As of unlisted (i.e. private and subsidiary) target firms and can be further aggravated in

case the target fails to perform as originally envisaged, or to comply with the terms of the deal during the integration

phase (i.e. moral hazard). As a multi-stage contingent payment mechanism, earnouts can effectively address the

respective concerns arising from ex-ante adverse selection and ex-post moral hazard considerationsand, thus, offer

a solution to the implied valuation disagreement of the merging firms (Kohers & Ang, 2000).1Therefore, given the

benefits originating from the reduction of merger valuation risk upon the use of earnouts, it is not surprising that

this payment mechanism has increased considerably, reaching approximately14% of all M&As in recent years, from

nearly 3% in the mid-1980s.2In a seminal paper on the effect of earnout use on the acquiring firm’s value, Kohers

and Ang (2000) show that earnout-based deals yield significantly higher acquirer short- and long- run risk-adjusted

returns, relative to deals settled in single up-front payments of cash or stock (hereafter referred to as the earnout

effect).

Confronted with the stylized features and valuation implications of this contingent payment mechanism, the

purpose of this paper is to further scrutinize the earnout effect, being mainly motivated by an established observation

in prior studies (which is further detailed in the sample statistics section of this paper). That is, the majority of acquirers

in earnout-based M&As are relatively small firms.3When compared to large firms, this asset class of acquirers is

characterized by significantly higher idiosyncratic stock return volatility (i.e. sigma), an aspect that has been mainly

attributed to the increased extent of asymmetric information between small firms’ managers and outside investors

(Campbell, Lettau, Malkiel, & Xu, 2001; Moeller, Schlingemann, & Stulz, 2004). Along these lines, prior studies have

established a strong link between acquirers’ sigma and the choice of payment method in M&As, as well as acquirers’

short-run risk-adjusted returns (Moeller,Schlingemann, & Stulz, 2007). Overall, evidence suggests that, depending on

sigma, acquirers’ risk-adjusted returns during the announcement of M&As may also reflect the release of new non-

M&A-related information overthe acquiring firm (hereafter referred to as the acquirer-specific information revelation

effect), as opposed to being solely reflective of the impact of the expectedeconomic benefits of the deal itself (Moeller

et al., 2004).

These empirical findings (i.e. the small size of acquirers in the majority of earnout-based deals and the high levels of

sigma within this portfolio of M&As) raiseimportant questions over the use of earnouts in M&As. In particular, they are

suggestive of the potential presence of the acquirer-specific information revelation effect, which may limit the preva-

lence of the earnout effect, or even render it elusive.It is therefore in principle a possibility that the perceived earnout

effect is distorted, due to the increased extent of information asymmetry between the managers of small acquiring

firms that typically engage in earnout-based M&As and outside investors. We further elaborate on these relations

through the following arguments.

First, we seek to establish a relation between acquirers’ sigma and the choice of earnouts in M&As. In this respect,

we consider that most targets in earnout-based M&As are privately held firms (Barbopoulos & Sudarsanam, 2012;

Kohers & Ang, 2000). As the market for private firms is typically illiquid (Draper & Paudyal, 2006), most targets’

managers are likely to prefer cash as the medium of exchange.However, cash is likely to be a ‘sub-optimal’ equilibrium

payment method for acquirers, particularly if it pays for difficult-to-value targets, which are challenging to integrate

into their core business (Fishman, 1989). Stock-financing, on the other hand, which is the closest contingent payment

alternative to implementing earnouts, could offer a direct solution to acquirers.4Yet, stock may also not be the

preferred financing method for acquirers as (a) under increased sigma, it may not serve the appropriate incentive

mechanism postulated by Hansen (1987) and put forward by Chang (1998)5and, therefore, may be a ‘sub-optimal’

contracting method in accommodating the target’s high valuation risk and (b) stock may dilute the (potentially small)

acquiring firm’s ownership structure.6Stock financing may also fail to represent the preferred payment method for

ALEXAKIS ANDBARBOPOULOS 5

the target firm’s managers as, among other reasons, (a) under increased sigma, it may raise misvaluation concerns

over the acquiring firm’s shares and, hence, result in the target firm’s management rejecting7this medium of exchange

(Chang, 1998), and (b) the shares of small acquirers are typically locked-up or cannot be sold or traded (to provide

immediate liquidity to the target firm) for a sufficient period following the announcement of the deal.

The above suggest that the use of earnouts is likely to: (a) ‘bridgethe gap’ in the inherent disaccord over the deal’s

intrinsic value, (b) provide cash immediately (by means of the first-stage payment) to the shareholders of the target

firm and (c) signal the unwillingnessof the merging firms to finance valuation-complex deals with stock. Both (a) and (b)

are likely to accommodate potential valuation concerns and liquidity shortages regarding the target firm, irrespective

of the acquiring firm’s information environment. Conversely,(c) is highly sensitive to the extent of information asym-

metry over the acquiring firm. Put simply,earnouts could potentially serve as an acceptable payment mechanism for

both acquirers and targets that agree to proceed with the deal upon disaccords over their valuations and alternative

transaction mediums of exchange. In this respect, as increased information asymmetry over the acquiring firm could

also be linked to, or eventrigger, such disagreements, it could motivate the use of earnouts.

Second, we establish a relation between acquirers’ sigma and the wealth effects of earnouts in M&&As. Accordingly,

we consider that acquirers in earnout-based deals are often small firms (Barbopoulos, Danbolt, & Alexakis, 2018a;

Kohers & Ang, 2000). As small firms are characterized by increased levelsof information asymmetry and, as also con-

firmed empirically, high levelsof sigma (Campbell et al., 2001), their heightened sensitivity to non-systematic factors

(i.e. high idiosyncratic risk) renders firm-specific information particularly valuable (Campbell et al., 2001). Such infor-

mation is primarily possessed by acquirers’ managers and is eventually reflected in security prices via information-

releasing events, such as M&As (Dierkens,1991).

As in the case of other major corporateevents (e.g. seasonal offerings, bond issuance), M&A announcements attract

media attention and place the acquiring firm under the spotlight of investors and analysts. In this specific setting, if the

capital market’sassessment of the deal is unbiased, the acquiring firm’s risk-adjusted returns should reflect the impact

of the expected economic benefits of the deal, in addition to the release (if any) of new non-M&A-related information

over the acquiring firm (i.e. the acquirer-specific information revelation effect) (Moeller et al., 2004). Therefore, as

acquirers’ risk-adjusted returns may fully,or partly, reflect the deal’s economic benefits, it could be that the perceived

earnout effect is, in fact, distorted (or subsumed) by the acquirer-specific information revelationeffect, the magnitude

of which (and consequent elusiveness of the earnout effect) depends on the extentof asymmetric information over the

acquiring firm. As the latter is expected to be heightened within the portfolio of earnout-based M&As, given the small

size of acquirers that typically engage in earnout-based deals, it is worth examining the interactionbetween acquirers’

sigma and acquirers’ risk-adjusted returns during the announcement period.

Lastly, this paper is also motivated by newly emerged features of earnout-based M&As that point to the growing

popularity of earnouts even in mega-deals.8Therefore, the suitability and wealth effects of earnouts in large deals

involving large acquiring firms that generally exhibitlow asymmetric information (and, hence, sigma), relative to small

acquirers, and for which the elusiveness of the earnout effect is expected to be marginal, remains to be thoroughly

investigated.

Our analysis is conducted using 35,121 M&A announcements between 1980 and 2016 (inclusive) made by US-

domiciled acquirers. A standard event-study methodology is adopted to measure the effect of each announcement

on the acquiring firm’s risk-adjusted returns. Toaccommodate self-selection concerns, a quasi-experimental design is

used based on which the earnout effect is measured in isolation via the PSM method. Toovercome potential issues per-

tinent to the functional form of the propensity score estimator,the Rosenbaum bounds method (Rosenbaum, 2009) is

employed.

Our main findings show that high-sigma (low-sigma) acquirers announce nearly 40% (20%) of all earnout-based

deals. However, only those earnout-based deals announced byacquirers exhibiting low sigma are perceived to enjoy

higher short-run risk-adjusted returns, relative to their non-earnout high-sigma counterparts. High-sigma acquirers

in earnout-based deals appear to break even, or even experience significant losses, relative to their non-earnout

high-sigma counterparts. The results from the PSM analysis confirm these findings by showing that it is earnout-based