Sold Below Value? Why Takeover Offers Can Have Negative Premiums

• Author: Utz Weitzel,Gerhard Kling
• Date: 01 June 2018
• DOI: http://doi.org/10.1111/fima.12200
• Published date: 01 June 2018

Sold Below Value? Why Takeover Offers

Can Have Negative Premiums

Utz Weitzel and Gerhard Kling∗

Many studies have acknowledged the existence of negative offer premiums where the initial bid

undercuts the target’s preannouncement market price. However, this phenomenon has not been

explained. Negative premiums occur frequently and are no measurement error. We demonstrate

theoretically and empirically that “hidden earnouts,” wheretarget shareholders participate in the

bidder’sshare of joint synergies, and corrections of overvaluation explain negative premiums.We

find that target shareholders profit from the consummation of a takeover even if the announced

offer has a negative premium. Our theory generalizes to low positive premiums with predictive

power for the bottom 25% of all premiums.

Suppose a bidder proposes to purchase a target for less than its market value before the

announcement. Should a target give such a bid any thought? On January 14, 2005, common

stock of Computer Network Technology Corporation (CNT) traded at $6.62 (NASDAQ closing

price). The following business day, McData Corporation announced its intention to acquire CNT

in a stock swap offering 1.3 shares of its NASDAQ-listed Class A common stock for each share

of CNT. Based on McData’s closing stock price of $4.25, the bid valued each CNT share at

$5.525 (1.3 ×$4.25) resulting in a negative premium of –16.5%. This is not a measurement

error and is consistent with Thomson’s M&A tear sheet.1Aside from the negative premium, the

takeover was not unusual. McData sought to acquire 100% of CNT’s shares and had no toehold.

CNT experienced losses, but was not bankrupt. The offer was supported by CNT’s management,

approved by CNT’s shareholders, and completed on June 1, 2005 under the terms of the initial

bid without competing offers.

Our US sample indicates that this is not an isolated case. On average, 8.4% of all mergers

and acquisitions (M&As) exhibit negative premiums from 1995 to 2011, reaching a peak of

14.1% in 2004. While the average premium in the sample period is 43.2%, the average size

of the negative premiums is 15.5%. Although there are several technical reasons for negative

premiums, primarily related to measurement issues, we find that negative premiums still exist

after correcting for, among others, adverse market movements, multiple deals, self-dealing,

Weare grateful to Rajkamal Iyer (Editor) and would like to thank the anonymous refereefor many constructive comments

and suggestions. We wouldlike to acknowledge the excellent copy-editing service provided by Wendy Jennings. We are

grateful forf inancial support fromthe University of Southampton, Utrecht University and Radboud University Nijmegen.

We thank Jaap Bos, Steven Kaplan, Michael Kirchler, Clemens Kool, Michael Koetter, Stephanie Rosenkranz, Karn

Simonyan, Roy Thurik, and seminar participants at the Tinbergen Institute, Erasmus University Rotterdam, University

of Innsbruck, Utrecht University, Georg-August-Universitaet Goettingen, German Institute for Economic Research,

University of Southampton and EFMA. All remaining errorsare ours.

∗Utz Weitzel is a Professor of Finance and Financial Markets in the School of Economics at Utrecht University and

a Professor of Experimental and Behavioral Finance in the Institute for Management Research (IMR) at Radboud

University, Nijmegen, The Netherlands.Gerhard Kling is a Professor of International Business and Management in the

School of Finance and Management at SOASUniversity of London in London, UK.

1Changing the reference point, such as four or eight weeks prior to the bid, still leads to a negativepremium of –16.3%

and –1.9%, respectively.The bid was also below CNT’saverage share price in 2004 ($6.30) and in 2003 ($7.91).

Financial Management •Summer 2018 •pages 421 – 450

422 Financial Management rSummer 2018

legal or regulatory restrictions, reverse mergers, announcement date inaccuracies, and marginal

deviations of premiums from zero. Our findings hold for a broad range of premium measures

based on the very first announcement of a takeover offer including market return corrections,

different windows, and various premium thresholds below and above zero. For data quality

reasons, we restrict our analyses to domestic US mergers. However, in an exploratory extension,

Table VIII indicates that negative premiums are a worldwide phenomenon.

Earlier studies have acknowledged the existence of negative premiums (Dong et al., 2006;

Moeller, Schlingemann, and Stulz, 2004; Bates and Lemmon, 2003; Officer, 2003, 2007; Schw-

ert, 1996). Yet no explanation has been offered. This paper provides theoretical and empirical

evidence that negative premiums exist and can be explained rationally. Target shareholders need

to be convinced that, ultimately, they will gain from the merger. Thus, a theory attempting to

explain negative offer premiums must allow for positive postmerger premiums for target share-

holders. Wepropose three explanations for negative premiums assuming rational, forward-looking

shareholders whose decisions are based on new information revealed by the offer.

The first explanation hinges on the fact that bidders pay with ownership when offering a con-

sideration in stock. Target shareholders profit twice from merger synergies. First, they negotiate

a share of synergies included in the offer premium through the share exchange ratio. Second,

they participate in the bidder’s share of synergies that accrue to the merged entity through the

target shareholders’ ownership in the joint entity. We designate the latter as “hidden earnouts”

as they are hidden in the bidder’s negotiated share and conditional upon synergy realization after

consummation of the merger. If the bidder offers less than the target’s market value, a favorable

share exchange ratio could provide target shareholders with sufficient ownership such that hid-

den earnouts make the deal worthwhile. In fact, if the target is relatively large, a combination of

negative premiums and hidden earnouts can be the only option for the bidder to pay the target

in stock without losing control over the merged entity. As hidden earnouts cannot be explicitly

included in a bid, the market reaction to such an announcement should be positive.

The second explanation refers to overvaluation as a target’s stand-alone market value could

exceed a fair bid constituting a negative offer premium. Bidders could detect overvaluation while

conducting valuations prior to the offer (Boone and Mulherin, 2007). The target management

might accept a negative premium fearing that the overvaluationmay soon be public knowledge. If

the target is overvalued, the market should react to the announcement of a negative premium with

negative abnormal returns, thus correcting the mispricing.2The lower postannouncement share

price then reflects the bid consisting of the target’s fair stand-alone value plus a positive premium.

As an alternative to overvaluation of a target’s fundamentals, prebid run-ups can constitute

speculative overvaluationof anticipated merger gains to the target (Betton et al., 2014). Excessive

run-ups may overshoot the announced offer resulting in a negative premium and a subsequent

negative market reaction.

The third explanation pertains to liquidity in the market for corporate control. Discounts in

illiquid markets for corporate assets can severelydepress M&A transaction prices (Schlingemann,

Stulz, and Walkling, 2002). If targets are financially constrained or distressed, market illiquidity

can push prices below fundamental values, as in fire sales (Shleifer and Vishny, 1992).

2CNT’sf iscal year ended 13 daysafter the announcement of McData’s offer. In the annual report, published prior to the

consummation of the merger, CNT’s management warned that “we maynot be able to achieve (...) profitability,” that “we

may be significantly harmed if we do not complete the pending merger,” and that “we havesignif icant indebtedness.”

CNT shares fell $1 to $5.62 at the announcement. McData shares rose 11 cents to $4.36 and $5 at consummation. Thus,

CNT’soffer premium and mark-up were negative.