The Effects of Valuation Adjustment Mechanisms on Acquisition Premium and Market Response
FENG Ke, XING Xiaoxu, HE Li
School of Economics, Peking University; School of Applied Economics, Renmin University of China; Faculty of Applied Economics, University of Chinese Academy of Social Sciences
Summary:
A contractual innovation in the M&A market, valuation adjustment mechanisms (VAMs) signal positive effects, such as reduced risk and M&A costs, for investors. However, whether accepting an excessive M&A premium to reach an agreement constitutes a reasonable VAM is an open question. Therefore, this paper theoretically and empirically analyzes the role of VAMs in transferring M&A risk and enhancing investor utility. This paper makes three main contributions to the literature. (1) Building on previous research, it establishes a game model of buyers and sellers in an information-asymmetric M&A market to theoretically analyze the role of a VAM in transferring M&A risk and enhancing investors' utility, and the correlations between the variables in the model are theoretically sorted. (2) The empirical analysis supplements two strands of the literature on the correlations between VAMs, M&A premiums, and market reactions. First, it examines the relationship between the details of VAMs (relative performance commitment size and contract length) and the premiums offered in M&A transactions. Second, as the market reacts to a VAM, this paper further explores the masking and threshold functions of the M&A premiums resulting from VAMs on the relationship between the VAM and abnormal stock returns. (3) This paper focuses on the follow-up after the VAM agreement is signed. The role of M&A premiums in the relationship between the contract details and VAM performance and between the market reaction and VAM performance are further analyzed. The data are mainly from the VAMs, M&A, and Stock Market Transactions Database of the China Stock Market Accounting Research (CSMAR). The sample comprises 2,564 asset acquisition cases from 2006 to 2020 in which the acquirer is a listed company, including 1,831 M&A transactions with a VAM and 733 M&A transactions without a VAM. Among the transactions with a VAM, 1,194 involve performance of the VAM, and 704 have completed performance requirements in every year. The three main findings are as follows: (1) The transactions with a VAM have higher M&A transaction premiums compared with those without a VAM, and those transactions also have larger relative performance commitments and longer betting periods. However, the contribution of the performance commitment to the premium varies. Excessively high relative performance commitments reduce the acceptance of betting agreements by high-quality acquirees, resulting in a crowding-out effect. A further grouping study using a subsample of unrelated transactions shows that investors are willing to pay a higher premium for a VAM. In other words, the prominent premium effect in the unrelated transaction group indirectly illustrates that a VAM reduces the risk of information asymmetry. (2) This paper investigates the intermediate masking effect of M&A premiums between VAMs and stock market responses. The results show that in general, the market response to a VAM is positive. This indicates that because VAMs are used to address information asymmetry, the market does not interpret relatively high premiums as a signal of overpayment within a certain range. However, in cases of severe information asymmetry, it is irrational to accept a very high premium to obtain a VAM agreement, because if the premium is too high, it creates an adverse selection problem. In this case, the partial masking effect of the M&A premium causes the market to react negatively. The threshold effect test confirms that above a certain threshold, the market has a negative reaction to the introduction of a VAM in an M&A transaction. (3) After addressing potential endogeneity in the model using the propensity score matching (PSM) and instrumental variable (IV) methods, further analysis of the realization of a VAM reveals that the probability of VAM realization is lower with more strict performance targets and longer horizons. However, high performance targets and long horizons can, to some extent, help firms obtain more funds through the premium, which will help them win the bet. Thus, the M&A premium has a negative intermediate masking effect on the relationship between contractual stringency and the probability of winning the bet. In addition, investor confidence is only well aligned with future VAM performance under certain conditions. M&A events with high or low premiums indicate high uncertainty, such that the stock market overreacts during the M&A window and fails to correctly predict future performance. These findings can help firms avoid valuation premium bias caused by overprotection, agency problems, and information asymmetry. Moreover, investors can use M&A premiums and VAM agreement details to mobilize positive emotions and enhance confidence.
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