Agreeing to participate or disagreeing to implement it?

Transcription

1 Agreeing to participate or disagreeing to implement it? Leonidas Barbopoulos and Dimitris Alexakis Abstract: We present new evidence on the announcement period returns of a sample of UK mergers and acquisitions (M&As) financed with earnout (contingent) versus non-earnout (noncontingent) payments and advised by financial advisors. We show that deals financed with earnouts in the presence of a financial advisor consulting the acquiror yield the highest announcement period returns to bidders shareholders. Such deals consistently outperform other earnout financed cases without the involvement of financial advisors, as well as non-earnout deals regardless of the presence of financial advisors. We argue that this result is mainly due to the ability of financial advisors to extract profitable opportunities, and where necessary structure the earnout contract s terms efficiently, leading to a very optimistic market reaction. Overall, earnout financing provides a more effective payment method in M&As, particularly when interacting with the presence of financial advisors, than that of other forms of payment methods. Keywords: Methods of Payment; Earnout; Mergers and Acquisitions; Financial Advisor; Announcement Period Returns. JEL Classification: G34 Preliminary Version Please Do Not Quote Please address correspondence to Leonidas Barbopoulos, School of Economics and Finance, University of St Andrews, The Scores, St Andrews, Fife KY16 9AL, UK. Tel: leonidas.barbopoulos@standrews.ac.uk. Dimitris Alexakis, School of Economics and Finance, University of St Andrews, The Scores, St Andrews, Fife KY16 9AL, UK. Tel: da30@st-andrews.ac.uk.

2 1. Introduction There is, by now, an established literature that studies mergers and acquisitions (M&As) success conditional on the choice of method of payment used to finance the deal as well as the involvement of financial advisors along with its reflection on the excess returns accrued to merging firms shareholders. See for example Myers and Majluf (1984), Travlos (1987), Eckbo, Giammarino and Henkel (1990), Fuller, Netter and Stegemoller (2002), Kale, Kini and Ryan (2003), Faccio and Masulis (2005), Eckbo (2009), Bao and Edmans (2011), Golubov, Petmezas and Travlos (2012). This literature provides convincing evidence that the involvement of skilled financial advisors and, more specifically, the involvement of top-tier advisors, known for their ability to identify profitable opportunities and create substantial synergies, interacts with the payment method in shaping the likelihood of success of the deal and thus the distribution of the bidding firm s abnormal returns (Golubov, Petmezas and Travlos, 2012). Extant literature appears also convincing that earnout financing provides a solution to valuation risk arising in smaller deals involving mainly unlisted targets and operating in intangible rich sectors (Kohers and Ang, 2000; Barbopoulos and Sudarsanam, 2012). Under the terms of an earnout contract the selling firm receives additional future payments provided it achieves certain pre-specified performancerelated goals. The earnout payment mechanism often involves two stages. In the first stage, the payment is delivered to the seller at the time of the deal announcement (in the form of cash, stock, or mixed payments), while the second (usually in cash) is delivered after a pre-determined period has elapsed following the deal announcement. Earnout contracts share the risk of possible misvaluation between the bidder and the target during the announcement period while they eliminate moral hazard problems in the post-merger or integration period. Provided that earnouts are complicated contracts and difficult to be structured, while they also give rise to substantial monitoring costs in the post-merger period, which can offset the majority of the aforementioned benefits, the involvement of financial advisor(s) is likely to affect their implementation, improve the efficiency of their design and estimate its terms more accurately. 1 However, we are not exposed into evidence on whether in deals financed with earnouts, versus non-earnout, the involvement of financial advisors enhances the likelihood of their success, which ultimately leads to higher announcement period returns to bidders shareholders. In this paper we aim to fill this void in the literature. 1 Cain, Denis and Denis (2011) provide a thorough discussion on the costs and benefits involved in M&As financed with earnouts.

3 vital. 6 The earnout usage in cases characterized by high valuation risk leads to positive returns Information asymmetry in M&As involving unlisted target firms 2 stands as one of the major sources of valuation risk. 3 One way of managing, and in most of the times mitigating this risk is to make part of the payment contingent upon the future performance of the target firm under existing management via the utilization of an earnout payment mechanism. Evidence presented in previous studies shows that earnouts have been used to manage valuation risk in acquisitions of private targets operating in the hi-tech and service industries (Kohers and Ang, 2000). In such industries, information asymmetry is high and the value of the firm is often dependent on the knowledge, skill, creativity, and flair of key personnel. However, the level of complexity involved when agreeing upon the (threshold) performance goals as well as the size of the deferred payment and the length of the earnout contract, which are balanced against the current and future risk exposure of the merging firms, stand as major challenges in earnout financed deals (Cain, Denis and Denis, 2011). 4 Along these lines, skilled financial advisors have been proven to be able to extract higher synergy gains while negotiating better terms in M&As (Bao and Edmans, 2011). 5 Servaes and Zenner (1996) demonstrate that the choice to use a financial advisor is strongly affected by the complexity of the deal, the type of transaction (takeovers versus acquisitions of assets), the acquiror acquisition experience and the degree of diversification of the target firm. As a result, the presence of financial advisors in M&As financed with earnouts is outperforming traditional means of financing, such as cash, stock and mixed ones that are fully delivered at the announcement time, and mirrors the market s optimistic perception of such concentrations. More recent literature confirms that the presence of financial advisors in M&As is associated with higher short-run gains to bidders while this effect is stronger under top-tier advisor involvement (Golubov, Petmezas and Travlos, 2012). Therefore, it should be value 2 Faccio and Masulis (2005) show that approximately 90% of UK (and Irish) acquisitions involve unlisted target firms while Draper and Paudyal (2006) report approximately 87% of the UK acquisitions involved privately held targets. However, Moeller et al. (2007) show that approximately only 53% of US acquisitions involve unlisted targets. 3 Discussions on the valuation risk of private target M&A can be found in Chang (1998), Fuller et al. (2002), Faccio et al. (2006) and Officer et al. (2009). 4 Cain, Denis, and Denis (2011) have adderees, via simulations, the complexity involved in ea financed deals while they provide convincing arguments regarding the size and length of the contracts. 5 Previous literature shows that M&As advisors stand as a very influencing factor affecting the outcome of M&As. Many aspects of their involvement along with their incentives have been examined in terms of their reputation and toptier classification (Bowers and Miller, 1990; Servaes and Zenner, 1996; Kale, Kini and Ryan, 2003; Golubov, Petmezas and Travlos, 2012) as well as the possible existence of a conflict of interest (Allen, Jagtiani and Peristiani, 2004; Kolasinski and Kothari, 2008; Bodnaruk, Massa and Simonov, 2009). In a more recent study, Bao and Edmans (2011) discussed the skilled advice hypothesis highlighting that investment banks, acting as advisors, are more capable of identifying higher synergy gains in target firms and can negotiate better terms. This leads to the investment bank fixed effect in bidder announcement returns. 6 Servaes and Zenner (1996) illustrate that the choice to use a financial advisor is positively related to the complexity of the transaction as is the choice to implement an earnout contract (Kohers and Ang, 2000).

4 adding in the existing literature to investigate whether the relative outperformance of earnout financed deals, when compared to non-earnout ones, is due to the ability of the earnout itself to reduce valuation problems and enhance future synergies or due to the presence of an investment bank consulting the acquiring firm and influencing the implementation (and structure) of this payment method, or the association of both. We argue that in complex cases, where synergy gains are not easily extracted due to information asymmetry problems or difficult to value assets, financial advisors are likely to propose such instruments in order to combat moral hazard, enhance the realization of the above-mentioned synergies and hence benefit both parties involved in the concentration. We test for these effects and provide new evidence in the existing literature. This paper presents new evidence on announcement period returns using a larger sample, near exhaustive, of UK M&As financed with various methods of payments (fully delivered at the announcement period, such as cash, stock, mixed, and contingent such as earnouts) and advised by M&As financial advisors. We test whether the use of earnouts as a structural payment mechanism, versus other payments that are delivered fully at the announcement period, increases the announcement period returns to bidders shareholders. As such this paper is the first to explore the effects of earnout financing on bidders short-run returns when M&As financial advisors are involved. Using a UK sample of M&As covering the period from 1986 to 2010 we present new evidence on the determinants of value creation from earnout financed deals. In the presence of financial advisors, M&As financed with earnouts yield the highest returns to bidders shareholders further indicating that the well documented evidence on value creation from deals financed with earnouts is mainly driven by the presence of financial advisors on the acquiring side of the deal. We argue that this is the outcome of the interaction between contingent payments and the involvement of specialised financial advisors, but mainly due to latter s ability to extract synergies and thus design such complicated contracts more effectively. We employ a two stage approach. The first stage comprises a standard univariate analysis of bidders announcement period returns. This involves comparing the risk-adjusted returns of bidders financing deals using earnouts relative to counterparts using traditional methods of payment only, such as full-cash (cash), full-stock (stock), and mixed payments (involving only cash and stock). The second stage of our analysis comprises a multiple regression analysis of the impact of earnouts on bidders announcement period returns, while controlling for the impact of several transaction- and merging institution-specific features. The main findings of our analysis indicate that the use of earnouts in M&As involving financial advisors leads to significantly higher announcement period returns to bidders

5 shareholders when compared to earnout deals not involving financial advisors as well as deals financed with cash, stock or a mixture of cash and stock payments. Earnout interacts with several transaction- and merging institution-specific characteristics (such as the target firm s listing status, the relative size of the transaction), in determining the announcement period returns of bidders. We show that the higher the size of the earnout contract, as a fraction of the total transaction value, the lower the announcement period returns accrued to bidders. Overall, the results presented in this paper suggest that the market reacts favorably to the use of earnout contracts in M&As involving financial advisors depicting a potential complementarity between the two. Our paper contributes to the literature in the following ways. First, this paper is the first to explore the effects of earnout financing on bidders short-run returns when financial advisors are involved in the valuation process of the deal. This provides the opportunity to incorporate factors specific to the financial advisor when assessing how the market reacts to M&A announcements. Second, provided that M&As financed with earnouts and involving financial advisors constitute cases with additional complexities to the bidding firm regarding the valuation of the target firm and the planning of the design of the contract, we investigate the announcement period returns to bidders shareholders. The remainder of the paper is organised as follows. Section 2 examines the incentives relating to the choice of payment method in M&A transactions, and how such a choice affects returns to bidding institutions. Section 2 also formulates reviews salient literature and presents testable hypotheses. Section 3 outlines the methods used to conduct the empirical analysis. This section also discusses the determinants of bidders announcement period returns. Section 4 provides a description of the data employed and discusses the main findings. Finally, Section 5 provides a conclusion. 2. Financial advisor involvement, earnout financing and testable hypotheses Two streams of M&A literature are combined in this paper. The first deals with the use of earnouts as a means of financing an acquisition while the second one deals with the role of financial advisors involved in the acquiring side of the deal Financial advisor involvement The role of financial advisors and their involvement in corporate takeovers has been thoroughly examined in the current M&A literature. Bowers and Miller (1990) demonstrate that

6 the choice of investment banker has wealth implications for the bidding firm s shareholders by establishing the Better Merger and Bargaining Power hypotheses. More specifically, it is concluded that an investment bank, and especially a top-tier one due to its better expertise, is able to identify firms with whom an acquisition would result in greater economic benefits. Nevertheless, it is implied that the market for takeover targets is sufficiently competitive so that no differential bargaining power between investment banks is observed. Michel, Shaked and Lee (1991), however, cast doubt upon whether the prestige of a financial advisor affects acquisition performance by depicting the relative outperformance of deals advised by Drexel Burnham Lambert, an investment bank from the second most prestigious group. Within the same context, Servaes and Zenner (1996) investigated the largest takeovers per year and compared acquisitions completed with and without investment bank advice. They conclude that transaction costs and, in part, contracting costs and information asymmetries are related to the choice to hire a financial advisor. More specifically, an investment bank is more likely to be consulted when the acquisition is more complex, when bidders have less previous takeover experience as well as when targets operate in an unrelated industry. Considering the investment bank s top-tier classification and the announcement period bidder returns, no significant relationship is identified. On the contrary Kale, Kini and Ryan (2003) report that the absolute wealth gain as well as the share of the total takeover wealth gain accruing to the bidder increases as the reputation of the bidder's advisor increases relative to that of the target. Similarly, Hunter and Jagtiani (2003) indicate that advisor quality and the number of advisors employed in a given transaction are important in determining the probability of completing a deal as well as the time required for its completion with top-tier advisors being more efficient. Recently published studies have shed more light on the influence of financial advisors on takeover outcomes. In their paper, Bao and Edmans (2011), show that investment banks matter for takeover outcomes. They establish the skilled-advice hypothesis indicating that investment banks, acting as advisors, are capable of identifying higher synergy gains in target firms. This consulting superiority of financial advisors results in a significant investment bank fixed effect in the announcement returns of M&A deals. Within the same context and contrary to prior studies, Golubov, Petmezas and Travlos (2012), report that top-tier advisors deliver higher bidder returns than their non top-tier counterparts, but in public acquisitions only. Their ability to deliver greater announcement period returns is proven to be sourcing from their reputational exposure in public concentrations along with their larger set of advisor expertise and capabilities.

7 Another issue that has been addressed by financial advisor M&A literature relates to the conflict of interests that may exist between the investment bank and the bidder being consulted by it. Allen, Jagtiani and Peristiani (2004) address this issue when financial institutions act both as lenders and advisors of a merging firm. In particular, target firms earn higher abnormal returns when the target's own bank is hired as merger advisor, consistent with the bank's role as certifier of the target's value to the acquirer. Within the same context, Kolasinski and Kothari (2008) find evidence that conflicts of interest arising from mergers and acquisitions relations influence analysts recommendations, corroborating regulators and practitioners suspicions. Furthermore, Bodnaruk, Massa and Simonov (2009) study holdings in M&A targets by financial conglomerates, in which affiliated investment banks advise the bidders, and show that advisors take positions in the targets before M&A announcements. These stakes are negatively related to the viability of the deal. Within the same context, Ismail (2009) indicates that investment banks might have different incentives when they advise on large deals as opposed to small ones. Finally, another aspect of the involvement of financial advisors in company takeovers relates to the fees charged by investment banks when advising merging parties. McLaughlin (1990) reports an average total fee of 1.29% of transaction value with a remarkable variation, nevertheless, between comparable deals. Furthermore, it is depicted that in almost 80% of contracts, the advisory fee is contingent upon the completion of the deal, thus incentivizing the investment bank to work towards the completion of the deal regardless of potential losses in synergy gains for the advised merging party. McLaughlin (1992) also demonstrates that bidding firms using less prestigious financial advisors offer significantly smaller premiums for takeover targets and enjoy higher announcement period abnormal returns. Overall, empirical evidence suggests that the presence of financial advisors influences the outcome of an M&A deal and affects the wealth gains accrued to the bidding firms shareholders. Despite the ambiguity concerning the impact of their reputation as well as the proper alignment of incentives, investment banks are depicted as skillful experts able to identify synergy gains in complex deals thus influencing announcement period returns Earnout financing Information Asymmetry constitutes one of the major issues in Mergers and Acquisitions as it may lead to an adverse selection effect. In his study, Hansen (1987), demonstrated that valuation risk, sourced from information asymmetry, can be controlled through the method of payment used to finance an acquisition. However, none of the payment methods mentioned

8 above makes the financing of the acquisition conditional upon post-merger performance of the target firm. In an earnout contract, an acquirer buys the target in two stages. An upfront payment of a large proportion of the agreed transaction value (in cash, stock or a mixture of the two) and a relatively smaller performance contingent earnout (usually cash). The second stage payment is made over a time period varying between three and five years contingent on the target reaching agreed milestones. Cain et al. (2011) report that the earnout component can be as high as 33% of the total purchase consideration. Kohers and Ang (2000) and Cain et al. (2011) for the US as well as Barbopoulos and Sudarsanam (2011) for the UK, report that earnout deals generate higher returns to acquiring firms than cash or stock acquisitions. Within the same studies it is pointed out that earnouts are more likely to be used in acquisitions where targets are more difficult to value (private companies), there is higher information asymmetry, the target belongs to an unrelated industry and the target has many intangible assets which are complex to value. More specifically, Kohers and Ang (2000) illustrate that targets with higher information asymmetry are suitable for the use of earnout and that this payment method results in positive event period abnormal returns for the acquiring firm. In their study, Cain et al. (2011) find that the earnout size is positively related to the uncertainty of target value, the choice of performance measure and the importance of target manager effort while the earnout length is negatively related to proxies for the noise in the performance signal. Reuer et al. (2004) indicate that the likelihood of the use of an earnout contract increases with the uncertainty faced by the bidding firm concerning the target value. When looking at the effect of earnouts in cross-border acquisitions, Datar et al. (2001) find that foreign bidders of US targets are less likely to use earnout than US domestic acquirers. This result is due to differences in accounting practices and corporate governance techniques between countries. Within the same context, Mantecon (2009) indicates that the use of earnouts yields positive announcement returns to domestic bidders while cross-border acquirers do not benefit from the earnout use as a means of financing a takeover. Furthermore, Barbopoulos and Sudarsanam (2011) indicate that US bidders enjoy significant gains from corporate takeovers when they utilize earnouts as an acquisition payment currency. US bidder gains from cross-border acquisitions appear significantly higher than gains from domestic acquisitions when bidders employ earnout correctly to finance their acquisitions. The correct use of earnout in international acquisitions provides a well calibrated payment technique that deals effectively with the higher level of adverse selection and moral hazard associated with cross-border acquisitions than with domestic targets. Finally

9 when examining the valuation effects of mergers of US financial institutions, Barbopoulos and Wilson (2011) find that bidders enjoy higher announcement period returns when using earnouts compared to other forms of payment. More specifically, earnout-financed bids outperform their non-earnout matching counterparts and the higher the size of the earnout contract, as a fraction of the total transaction value, the higher the announcement period returns of bidders. Overall, earnout financing constitutes a payment mechanism that reduces the probability of overpayment and increases the probability of success during the integration period as part of the transaction value is dependent on the future performance of the target firm. Despite their complexity, when properly implemented earnouts are proven to be able to generate greater announcement period returns outperforming alternative means of payment and offer an intuitive solution in cases with substantial overpayment risk Testable hypotheses As mentioned above, earnout contracts do not constitute a simple and easy-to-use method of payment. They require intense negotiations between bidders and targets in order to agree upon the performance-related thresholds regarding the second payment. The complexities regarding the valuation of the target, the uncertainty related to its post-acquisition operating performance, caused by moral hazard issues, and the avoidance of an adverse selection effect, related to information asymmetry, render this method of payment appropriate for acquisitions of targets exposed to the above risks. Given the high percentage of the earnout component (up to 33% of the total purchase consideration according to Cain et al. (2011) along with the willingness of target shareholders to bind themselves to the post-acquisition performance of the merged entity, it becomes evident through numerous studies that this financing decision is optimal for acquisitions of difficult to value targets such as unlisted firms, or firms belonging to industries characterized by high intangible assets (Kohers and Ang, 2000). Therefore, the implementation of an earnout provision, especially in cases similar to the above that have been proven to be optimal for its use, results in acquirors experiencing greater gains than their non-earnout counterparts. Consequently, our first hypothesis is as follows: H1: Bidders financing M&A bids with an earnout provision yield higher announcement period returns to their shareholders, compared to returns generated from M&A bids financed with nonearnout payment methods.

10 On the other hand, the role of financial advisors involved in the deal has been thoroughly examined. Nevertheless, certain conflict of interest issues arise, mostly dealing with whether these consulting firms have the right incentives when advising a concentration (Allen et al. 2004, Kolasinski et al. 2008, Bodnaruk et al. 2009). Despite the above, investment banks, acting as financial advisors have been proven to be better able to distinguish synergy gains in potential targets and have also been shown to be able to generate greater announcement period returns( Bao and Edmans, 2011). More specifically, financial advisors have been established to be playing a significant role in takeover outcomes. The skilled advice hypothesis indicates that investment banks consulting the acquiring firm are better able to identify synergy gains in targets. Subsequently, this consulting superiority is reflected through the investment bank fixed effect in the announcement period abnormal returns. Earnouts, as a means of financing an acquisition, have also been proven to be able to extract synergy gains from difficult to value targets due to the ability of their design to maintain the target firm s management. The performance-related thresholds that have been agreed upon in the contract incentivize the target s administration towards the realization of those goals which, ultimately, benefit both parties. It can therefore be the case that financial advisors, due to their skillful expertise in identifying synergy gains in target firms and implementing the appropriate instruments to extract them, are better able to notice such opportunities in high valuation risk firms. Due to the complexities surrounding such deals, sourced from information asymmetry and moral hazard, an earnout provision is subsequently implemented, as the investment bank realizes its appropriation for such cases and is skillful enough to design the contract efficiently. Therefore, our second hypothesis consists of two parts and is as follows: H2a: Deals involving an earnout provision and a financial advisor consulting the acquiror yield greater announcement period returns to the bidding firms shareholders than deals involving a financial advisor consulting the acquiror and not involving an earnout payment. H2b: Deals involving an earnout provision and a financial advisor consulting the acquiror yield greater announcement period returns to the bidding firms shareholders than deals not involving a financial advisor and also not involving an earnout payment.

11 Taking into consideration the above, it can be the case that the announcement period abnormal returns accrued to the bidding firms shareholders in earnout-financed concentrations are influenced by the presence of financial advisors. Therefore, it needs to be addressed whether the significant outperformance of deals involving this contingent payment method sources from the earnout itself, or whether it is also related to the presence of an investment bank consulting the bidder. Earnouts constitute a complex transaction method that requires intense negotiations and can easily result in a failure or a legal dispute. Therefore, the acquiring firm alone may not possess the necessary expertise to properly design and implement this payment method in contrast to the financial advisor. As a result, the market s reaction reflects both the investment bank fixed effect and the risk-mitigating properties of an earnout provision. The latter indicate a potential complementarity between earnouts and financial advisors which leads to greater announcement period returns. The market acknowledges the investment bank s expertise and in addition to the risk hedging properties of earnouts reacts positively as depicted in the acquiring firms wealth gains. 3. Methods In this sub-section discussed the methodology used to test the aforementioned hypotheses and derive the main results of the paper. Methods for calculating abnormal returns around M&As announcements are therefore presented. Subsequently, the univariate and multivariate methods of analysis are outlined Measurement of abnormal returns The commonly used method in estimating abnormal returns in response to an event requires long estimation period returns series that is free from the effect of the event under analysis. Nevertheless, the current sample is composed of many bids announced by the same acquiring firm within a small period of time. Therefore, such method cannot be applied. Alternatively, in line with numerous studies with similar sample characteristics (Fuller et al. 2002, Faccio et al. 2006) the announcement period abnormal returns are estimated using the market-adjusted model (equation 1): (1)

12 Where: AR i,t, is the abnormal return to bidder I on day t, R i,t is the return on firm/bidder I at day t, R m,t is the value-weighted market return index at day t. The announcement period cumulative excess return is the sum of the abnormal returns in the 5-day window (t-2 to t+2) surrounding the bid announcement, day t=0, as outlined in equation 2: (2) 3.2. Univariate and multiple regression analysis At first, the announcement period abnormal returns of UK acquirers are analyzed by method of payment used (cash, stock, mixed, and earnout) and target listing status (private, public, and subsidiary). The analysis is also divided into sub-categories related to the presence of a financial advisor for the acquiring firm. Subsequently, differentials between the gains to bidders using cash, stock or mixed payments for different target listing statuses and the gains to bidders using earnouts are calculated. To assess the comparative performance of different groups of acquirers, the difference in means is tested using the t-test along with the difference in medians using the Wilcoxon test. Subsequently, we further examine the impact of financial advisors in earnout financed deals on a multivariate framework where the effects of several other factors in shaping the announcement period bidders returns are simultaneously controlled. Extant literature demonstrates that a number of control variables influence acquirer s value gains. Such factors include the method of payment, bidding firm s age, the relative size of the deal, the target firm s listing status, the industry affiliation of the merging firms and the target s domicile and operating legal system. Furthermore, this empirical paper includes certain new factors that aim to explain the bidding firm s returns. They consist of the existence of a financial advisor, a further exploration of the listing status of the immediate parent of subsidiary targets, the legal system in which the target firm operates, and certain key financial ratios of the bidder such as the cash ratio (total cash and cash equivalent over total assets) and debt ratio (total debt to common equity). In particular, the following equation is estimated in a nested form: (3) Where: the intercept, α, accounts for the abnormal returns accrued to bidders after accounting for the effects of all the explanatory variables X i. The dependent variable, CAR, is the five-day announcement period cumulative abnormal return of acquirers. The vector of explanatory

13 variables, X, includes a number of factors that are known to affect bidders gains. Such factors consist of: Earnout as a method of payment (EA): Previous research indicates that acquisitions of difficult to value targets, such as private targets operate in the high-tech industry generate greater bidder announcement period returns when financed with an earnout component (Kohers and Ang, 2000). Therefore to account for the potential implications of the occurrence of an earnout on bidder gains, a variable taking the value of one when there exists an earnout and zero otherwise is included in equation (3). Bidder s age (BAGE): Information asymmetry between the merging firms influences heavily the announcement period returns accrued to bidders shareholders. Draper and Paudyal (2008) and Zhang (2006) suggest that investors tend to have more information on firms with longer trading history which results in lower information asymmetry. Therefore the age of the acquirer (measured by the log of number of days between the announcement day and the first record of the company in Datastream) is included in equation (3). Relative size of the deal (LRS): Current literature (Fuller et al. 2002) depicts that the bidders gains are positively related to the relative size of the bid (measured as the log of the deal value over the market value of the acquirer). Hence this variable is included in equation (3). Diversification (CROSSIND): Extant literature (Barbopoulos et al. 2012) shows that if target and bidder belong to the same industrial sector, the integration of the two firms should be easier and the synergy gains higher. On the other hand, firms acquiring targets operating in unrelated sectors may also gain from diversification. Therefore to control for the potential effect of corporate diversification a dummy variable taking the value of one for cross-industry bids (i.e. target and acquirer do not have the same 2-digit SIC code) and zero otherwise is included in equation (3). Target s domicile (CROSSB): Domestic and international deals have been proven to be affecting the bidding firm s value gains (Conn et al. 2005). Domestic acquisitions can be perceived as less risky than crossborder acquisitions as there is less information asymmetry about the target firm, especially in those cases where it is a listed firm. Therefore, in order to control for the effect of international deals and how they affect bidder returns a dummy variable that equals one when bidder and target reside in different countries and zero otherwise is included in equation (3). Target s operating legal system: Current literature (Barbopoulos and Paudyal, 2012) depicts that the target firm s operating legal system interacts with the bidding firm s

14 announcement period returns as the legal tradition of the target's domicile interacts with target's status and method of payment in shaping the net gains of acquirers. Therefore dummy variables that equal one when the acquired company s legal system is the Common Law or the Civil Law and zero otherwise are introduced in equation (3). Additional indicator variables: Certain new factors are introduced in this paper that aim to explain the wealth effects arising to bidding firms shareholders. The main variable under examination consists of the advisors involved in the deal and, more specifically, financial advisors. Therefore a dummy variable for the existence of financial (AFAE) advisors is included. Furthermore, the target s listing status has been proven by empirical studies to be influencing the announcement period acquirer returns. Dummy variables are hence, created for those cases where the acquired firm is private (PRIVATE) or subsidiary. Finally, key financial ratios of the acquiring firm (such as the ratio of total cash and cash equivalents to its total assets, CASH_RATIO, and the ratio of total debt to its common equity, DEBT) signal information about the bidder s financial status and probability of default. Therefore, they are included in equation (3). A more detailed presentation of all parameters used in this paper is given in the Table Data and Results This section presents the data and offers a discussion of the main findings of our empirical investigation. Section 4.1 outlines the sample of M&As transactions and presents descriptive statistics. Section 4.2 discusses the results from the univariate analysis. Finally in section 4.3 we present and discuss the results from the multivariate cross-sectional analysis The sample The sample consists of takeover bids announced by UK public firms between 01/01/1986 and 31/12/2010 and recorded by the Security Data Corporation (). records 31,658 cases of M&As bids involving UK acquirers within the sample period. In order for a bid to remain in the sample, it must meet the following criteria: first, the acquirer is a UK public company listed in the FTSE and has a market value of at least $1 million, measured four weeks prior to the announcement of the bid. To avoid the insignificant effects of very small deals, the transaction value needs to be at least $1 million. To ensure that the acquirer enjoys control of the target, only acquisitions of at least 50 percent of target equity are included in the sample. Targets of all listings (listed, private and subsidiary) and domicile (UK or non-uk) are included in the sample. To avoid the confounding effects of multiple bids, bids announced within 5-days

15 surrounding another bid by the same bidder are excluded. Furthermore, the daily stock price and market value of the acquirer need to be available from Datastream. Buybacks and repurchases are excluded from the sample. Cases where either bidder or target firms belong to regulated industries (Healthcare, Financials, Energy and Power) or to the government are excluded from the sample. Finally, considering the method of financing the acquisition, the percentage of unknown, provided by, must be less than 100% so that the sum of cash, stock and other payments equals 100%. The above criteria are satisfied by 6,432 bids and remain in the sample. 1,505 bids comprise earnout contracts of these deals involve financial advisors while only 331 of those belong in the earnout financed deals Sample Characteristics All Acquisitions Table 2 depicts the frequency of acquisitions in the UK takeover market according to the acquired firm s location and industry as well as the method of payment used, the presence of a financial advisor for either bidder or target and the acquired firm s listing status. Earnout financed acquisitions constitute 23.4% of the sample. The remaining 76.6% involves cash, stock or mixed payments. Nevertheless, the use of earnouts has increased dramatically since the mid 80 s reaching 31.73% and 33.72% of total M&As activities in the years 2006 and 2007 respectively as compared to just 14.05% in Cash along with mixed payments constitute the two dominating methods of payment (accounting for 44.37% and 48.94% respectively) followed by stock which accounts for just 6.69%. A reason for the relatively low percentage of acquisitions fully financed with stock is the severe regulatory regime in the UK which generally prohibits acquisitions fully financed with equity. Almost 32% of the sample deals include a financial advisor for the acquiring firm and 27.16% a financial advisor for the target firm. The above indicate that one third of all acquisitions is accompanied by a financial advisor rendering its influence substantial in takeover outcomes. Furthermore 331 deals are characterized by the simultaneous presence of both an earnout and a financial advisor. Cross-border acquisitions, i.e. UK bidders acquiring non-uk targets appear relatively frequently (28.81% of sample) while acquisitions of non-listed targets, i.e. acquisitions of private and subsidiary targets, seem to be dominating the sample accounting for 90.58% (59.56% and 31.02% respectively). More specifically, 9.2% of all acquisitions consist of subsidiary targets with a private immediate parent, 13.85% consist of subsidiary

16 targets with a public immediate parent and 7.85% consist of subsidiary targets with a subsidiary immediate parent. The remaining 9.42% consists of acquisitions of public firms. Cross-industry concentrations represent 49.32% of the sample while 49.32% of the deals involve acquisitions of targets belonging to industries characterized by high intangible assets (i.e. High-Tec, Consumer Products and Services and Media and Entertainment) Acquisitions involving earnouts In this section the sample is restricted to only those deals involving an earnout payment. In Table 3, deals financed with earnouts are dominated by acquisitions of private targets accounting for 85.12% and followed by acquisitions of subsidiary targets representing 13.75%. Furthermore, subsidiary targets whose immediate parent is a private firm account for 5.78%, subsidiary targets whose immediate parent is a subsidiary firm account for 2.26% and subsidiary targets whose immediate parent is a public firm account for 5.71%. Acquisitions of public targets, very rarely involve an earnout payment as they account for merely 1.13%. Cross-border acquisitions represent 20.93% of earnouts indicating their appropriation for domestic cases (Datar et al. 2001). Considering the target s industry classification, almost 50% of earnout financed deals involve targets belonging to a different industry than the acquiring firm while almost 60% of acquired companies belong to industries characterized by high intangible assets. Considering the advisors involved in the deals, almost 22% of acquirers are being advised by a financial advisor while 25.65% are being advised by a legal advisor Finally, considering target advisors, almost 17% of targets are being consulted by investment banks. The use of financial advisors seems to be following the general trend of earnout use. As in the case of earnout occurrences, the presence of a financial advisor for the acquiring firm increases dramatically during the ten years between 1991 and 2001 and subsequently drops, in the aftermath of the dot-com bubble. Subsequently, it once again increases during the years only to start dropping again during the credit crunch crisis of Deal Characteristics Table 3 presents mean and median deal values according to target listing status, method of payment, industry, target firm s domicile and financial advisor presence. The average deal value of all deals is around $134 million with a median value of almost $11 million. Deals involving public targets exhibit the highest average and median deal values ($920 million and $83.45 million respectively) followed by deals involving subsidiary and private targets ($102.4 million

17 and $13.8 million and $26.4 million and $7.95 million respectively). Earnout financed acquisitions exhibit average and median deal values of $22.5 million and $8.85 million respectively which are the lowest when compared to the alternative means of payment (cash, stock or mixed). Nevertheless, this is somewhat expected as acquisitions financed with an earnout provision mostly involve small unlisted targets which render the transaction value relatively small. Considering the financial advisors involved in the deal process, it is shown that deals including a financial advisor are much larger in size than those which do not. More specifically, the presence of a financial advisor for the acquiring firm increases the average deal value from $21.22 million to $375 million while the median transaction value also increases from $7 million to $36.17 million. When there exists a financial advisor for the acquiring firm along with an earnout provision the average and median deal value is greater than when there exists an earnout provision without an advisor reaching $51.19 million and $17.13 million respectively. The same observation persists across all different target listing statuses indicating that earnout deals which include a financial advisor for the bidder are much larger in size than earnout deals without one. Nevertheless these values are significantly smaller than when there exists a financial advisor for the bidder without the presence of an earnout. In those cases the average and median deal values climb to $ million and $43.65 million respectively. Considering the target firm s domicile, cross-border acquisitions exhibit much larger average and median deal values ($ million and $18.88 million) than domestic ones ($66.39 million and $9 million). More specifically, cross-border acquisitions of public targets exhibit an average deal value of $2.1 billion and median value of $ million. Acquisitions involving targets in the same industry exhibit a higher average deal value than when the target firm belongs to a different industry ($ million and $79.27 million respectively). Nevertheless this difference is not as substantial when looking at the median values ($11.68 million and $10.43 million respectively). Finally acquisitions of firms that belong to a high intangible assets industry are characterized by lower average and median deal values than crossindustry or same industry acquisitions ($67.1 million and $10.2 million respectively). The above simplistic analysis demonstrates that the vast majority of earnout financed M&As deals is composed of domestic acquisitions of unlisted targets belonging to an industry characterized by high intangible assets, and hence valuation risk, while almost 22% of them are accompanied by an investment bank consulting the acquirer. Furthermore, earnout deals are much smaller in size than non-earnout ones. Nevertheless, when there exists an investment bank consulting the acquirer, earnout financed acquisitions increase significantly in size across all

18 different target listed statuses. The above effect of the presence of a financial advisor on the bidding side of the deal is also present in non-earnout acquisitions verifying the conclusion that deals including financial advisors are generally larger in size Univariate analysis of announcement period returns Table 5 reports the findings of our univariate analysis of announcement period returns. Results are presented according to method of payment used and target listing status. The analysis is also divided into sub-categories related to the presence of a financial advisor for the acquiring firm. Subsequently, differentials between the gains to bidders using cash, stock or mixed payments for different target listed statuses and the gains to bidders using earnouts are calculated as well as the gains to bidders using a financial advisor and the gains to acquirors not using one. Panel A reports the mean and median 5-day announcement period returns for all acquisitions. Earnout financed deals are depicted to be outperforming alternative means of payment averaging 1.70% with a median return of 0.64% which is also the highest among other financing methods (consistent with earlier studies such as Kohers and Ang, 2000; Barbopoulos and Sudarsanam, 2012). Earnout deals involving unlisted targets, which are depicted by literature to be optimal for their use, illustrate an average and median return of 1.70% and 0.63% respectively. When compared to alternative means of payment earnout financed deals involving such targets only outperform cash deals with just the average difference being significant at 1.00%. Among acquisitions involving earnouts, deals involving a subsidiary target with a private immediate parent demonstrate the greatest average and median abnormal returns (2.83% and 1.22% respectively both significant at 1%). This is somewhat expected as bidders acquiring such firms are exposed to greater valuation risk due to the complicated status of the target. Therefore the implementation of an earnout contract should be regarded as more appropriate thus resulting in a positive market reaction. In order to assess the impact of financial advisors specifically, Panel B restricts the sample to only those cases where there exists a financial advisor for the acquiring firm. Earnout financed deals still depict the greatest average and median abnormal returns (2.48% and 1.18% respectively, both significant at 1%) which are also much larger than those presented in panel A. Furthermore, under the presence of a financial advisor bids including this contingent payment method outperform those that do not by 1%, significant at 5%, while the median difference is 0.54% also significant at 5%. Furthermore, deals involving an earnout provision and unlisted targets now depict much larger average and median returns than before (2.57% and 1.27% respectively, both significant at 1%). Finally, once again, deals involving subsidiary targets with a

19 private immediate parent yield the greatest returns among the earnout group (5.63% and 3.98% respectively, both significant at 1%) and are also much larger than those in panel A. The above results indicate that the presence of financial advisors significantly increases the wealth gains accrued to the bidding firms shareholders in earnout financed acquisitions. Especially in those cases where earnout literature depicts their use to be optimal, i.e. unlisted targets, the average and median returns corresponding to acquiring firms equity owners are significantly increased. In order to better assess the influence of financial advisors, in Panel C, the sample is restricted to those cases where there does not exist a financial advisor consulting the bidding firm. This separation should give us a first glimpse of the impact that investment banks have on bidders wealth gains in earnout financed concentrations. Earnout financed acquisitions now depict the smallest average and median returns between all Panels (1.48% and 0.53% respectively, both significant at 1%). When compared to non earnout financed acquisitions, deals involving this contingent payment are depicted to be outperforming only in terms of average returns by 0.45%, significant at 5%. Interestingly, and in contrast to the case where there exists a financial advisor in Panel B, earnout financed deals when compared to stock financed deals do not exhibit a significant outperformance. As shown by Hansen (1987), stock financing offers some risk-mitigating advantages, especially in cases with asymmetric information that favor the acquiring firms shareholders. Under the presence of a financial advisor, a significant outperformance of earnout financed bids is observed whereas when there does not exist an investment bank advising the acquiring firm the aforementioned outperformance becomes insignificant. Furthermore, acquisitions of subsidiary targets with a private immediate parent financed with an earnout now exhibit much lower average and median returns (1.94% significant at 5% and 0.69% significant at 1% respectively). Finally, Panel D exhibits the differences in portfolio returns between cases that include a financial advisor and those that do not. In earnout financed deals, the presence of an investment bank yields greater mean and median announcement returns by 1% significant at 5% and 0.66% also significant at 5% respectively. In non earnout acquisitions the presence of a financial advisor only increases the mean return by 0.44%, significant at 5%, while the median increase is rendered insignificant. Acquisitions, characterized by literature to be optimal for earnout use, such as those involving unlisted targets, are also benefited by the presence of a financial advisor in terms of the wealth gains accrued to the bidding firms shareholders. More specifically, the existence of an investment bank translates to a 1.11% increase in average bidder gains, significant at 1%, and a 0.77% increase in median acquiror returns, significant at 5%. Once again subsidiary targets with a private immediate parent as well as subsidiary targets with unlisted immediate parents which,