Avoiding Lemons in M&A Deals

With the recent rise in corporate share prices, swelling cash accounts and a weak dollar, prognosticators are heralding the return of strong mergers and acquisitions activity, particularly in the high-tech, pharmaceutical and banking sectors. Yet if history provides any guide, many of these deals will fail to generate any real value for the shareholders of the acquiring company, and a good number will ultimately become wealth-destroying propositions.

New insights into why this happens have come from seemingly unrelated markets, including those for used cars, labor and insurance. In 2001, George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz shared the Nobel Memorial Prize in Economic Sciences for their work on these markets and the failures that can arise when buyers and sellers possess different information about the goods or services being exchanged (Stiglitz, 2000). Strategic management researchers and financial economists have used these insights to understand why some M&As perform poorly and to identify ways that managers can cope with the challenges presented by knowledge discrepancies across bidders and targets.

The fundamental problem lies in two inherent features of many M&As: the acquiring company’s struggle to value the target’s resources and the need for the parties involved to agree on a price. The process of due diligence provides a useful starting point for obtaining detailed and reliable information about the quality of the resources to be acquired, yet often fails to unearth the sort of deep, and often tacit, knowledge about the target’s resources that can ultimately determine the success or failure of an acquisition. Moreover, time pressures, organizational complexity, unfamiliar product or geographic markets and the challenges surrounding the appraisal of intangibles can hamper a suitor’s valuation and negotiation efforts. Sellers often face problems in conveying the true value of their resources and capabilities to a buyer in a credible fashion. This is because sellers have natural incentives to inflate their representation of the quality of the offering in order to command a higher sale price, while acquirers already assume that sellers are presenting their best face. When suchinformation asymmetries exist across bidders and sellers, attractive deals may simply fall through; but for those deals that are completed, acquirers are likely to overpay. In other words, acquirers run the risk ofadverse selection, or winding up with a “lemon.”

What remedies, if any, exist for these problems? How should executives relying upon acquisition-led growth in coming years respond? Recent research in strategic management and financial economics has identified three distinct possibilities: selecting an alternative ownership structure, crafting a contractual agreement and utilizing information generated by other markets.

Ownership Solutions

Information asymmetries create problems because an acquisition is a terminal sale and the buyer bears the risk of overpayment. Other ownership arrangements exist, however, which lack these two features yet still allow companies to combine resources and generate synergies. One alternative is an equity joint venture. A recent study of 200 U.S. companies found that while 82% of managers view acquisitions and alliances as two different ways of accomplishing the same growth objectives, only 14% have specific policy guidelines or criteria for choosing between the two (Dyer et al., 2004). One important rule of thumb is that when the acquirer has an inadequate understanding of the resources to be acquired, and the seller is apt to possess private information, a joint venture or other form of alliance can be a very attractive option.

For example, a company can use a joint venture to test the waters and then acquire the partner’s equity stake, or the partner in full, if the acquirer likes what it sees. In this sense, the joint venture can be compared to rent-to-own arrangements in other markets, which allow users to experiment with products prior to purchase. In the case of a joint venture, the sharing of ownership and the possibility of termination also provide incentives for information sharing. Recent research shows that the stock market rewards companies investing in domestic or international joint ventures when the business is outside of the company’s core product market and is therefore more likely to be subject to information asymmetries (Reuer and Koza, 2000). A related analysis finds that strong learning effects exist for technology transfer and manufacturing alliances prior to the acquisition of a target company (Porrini, 2004).

Another study highlights several conditions under which due diligence investigation through alliances is likely to be attractive — for instance, when the cost of collaboration is small relative to the benefit of choosing the right target and when uncertainty is resolved over the medium term (Arend, 2004). A classic example of this solution at work is Whirlpool Corp.’s acquisition of the European domestic appliance business of Royal Philips Electronics N.V. (Nanda and Williamson, 1995). Whirlpool executives were convinced that they could add value to the business in several ways but were concerned about many aspects of the acquisition, including the loyalty of the dealer network and the strength of the consumer franchise behind the brand. Not surprisingly, executives from Philips and Whirlpool had very different information and assumptions about the business, which led to widely different valuations. To break through a potential negotiations gridlock, Philips offered Whirlpool a majority stake in the business and right to acquire the remaining 47% within three years, which it did. Other recent research and case studies note that companies are using joint ventures as sequential investments in biotech and other high-tech industries. As another example, Cisco Systems Inc. is widely known to have an acquisition-led strategy, yet the company relies on small equity investments as stepping stones for approximately 25% of their acquisitions (Dyer et al., 2004). See sidebar

Contractual Solutions

When confronting information asymmetries about strategic resources instead of implementing hybrid organizational forms such as joint ventures, decision makers can devise unique contracts to manage the risk of adverse selection while still obtaining complete ownership of the target company. For example, Siebel Systems Inc. announced in April 2004 that it would acquire Dublin-based Eontec Ltd., a provider of retail banking technology in Ireland, for $130 million. However, Siebel structured the deal such that initially, Eontec would only receive $70 million, yet would obtain as much as $60 million more if it met performance milestones.

This alternative is termed acontingent earnout, as it enables acquirers to avoid upfront lump sums in favor of deferred variable payments that are tied to business performance. Often the management of the target company continues to operate the business, and the earnout provides them with a performance incentive (Kohers and Ang, 2000). While the acquirer using an earnout is in no better position to value the resources in question, the transfer of overpayment risk from buyer to seller lessens the effects of information asymmetry, and the seller’s willingness to accept the deferred payments provides a positive and credible signal of its resources’ worth. Recent research indicates that earnouts can substitute for the solution of shared ownership and can be useful for acquiring companies that are young, privately held and possessing knowledge bases that are dissimilar to the acquirer (Reuer and Ragozzino, 2005).

If earnouts are so useful, why are they not used more often in M&A deals? Apart from their complexity, earnouts can produce other problems. First, they can create unintended incentives that might be at odds with the long-term interests of the business. If the managers of the target company operate the acquired unit, they will naturally seek to maximize the payout formula (perhaps basing it on net income or revenue growth) over a short interval (for example, two to five years), even if this means neglecting maintenance or other costly activities that yield benefits after the payout period ends. Second, earnouts are problematic for acquisitions needing structural integration because coordinated operation makes it difficult to appraise the target’s stand-alone performance and ties the target’s payout to actions beyond its control.

Under these circumstances, decision makers might find it desirable to use stock as a method of payment that reallocates a portion of the overpayment risk from the buyer to the target in a similar way. This solution, however, has an important drawback: Just as the seller may possess private information on the quality of its resources and capabilities, the acquirer may have information about its future performance prospects that is not broadly known by equity investors. It follows that executives from the acquiring company have an incentive to use stock to pay for an M&A when they believe their company is overvalued (Rhodes-Kropf and Viswanathan, 2004), which makes such payments less attractive to target companies. Given their combination of merits and demerits, earnouts are more commonly used in acquisitions of privately held young companies, since these targets often are subject to the risk of adverse selection and possess human capital that is both attractive and requires autonomy.

Market Solutions

For acquirers seeking full control, however, an alternative that avoids some of the drawbacks of earnouts is to focus on selecting targets that are already publicly traded. Recent evidence indicates that newly public companies are, in fact, routinely scooped up in the M&A market, as compared to private companies or more established public companies (Field and Karpoff, 2002). In fact, targets often pursue sales and an initial public offering simultaneously — more recently, companies such as Advertising.com, Borden Chemical, Brightmail and Noveon were acquired just as they filed to go public.

How does the operation of the IPO market alter the risks and inefficiencies of M&A deals? Two explanations based on information spillovers across IPO and M&A markets have been suggested (Reuer and Shen, 2004). The process of going public can reduce information asymmetries because information about the target company may be revealed through a variety of sources, including road shows (which introduce the company to members of the underwriting syndicate, analysts and key prospective investors) and through the disclosures required for registration and listing. More importantly, once the company is publicly traded, the equity market aggregates heterogeneous information held by investors in order to place a value on the potential target company. For instance, before PayPal Inc. went public, eBay Inc. sought to acquire the company in order to access their antifraud capabilities, yet the companies could not come to terms on price. Once PayPal went public, however, the equity market certified the value that PayPal claimed it was worth in initial M&A negotiations, and eBay completed the acquisition.

The IPO market can also mitigate the effects of information asymmetry through signals sent by the company during the process of going public. The CEO of Veridian Corp. (which was acquired in 2003 by General Dynamics Corp.) noted the importance of creating the right first impression during the IPO process by achieving alignment through selection of the right stock exchange with which to list and the right investment bank with which to work. Companies that are associated with reputable institutions (investment banks or venture capitalists, for example) or that incur the direct and indirect expenses of going public may be less likely to be lemons, as compared to privately held targets that are unable to tap into the reputation capital of others or are unable to demonstrate that they can bear the costs of going public. In effect, acquirers can turn to the equity market and its institutions to aid in the work of separating the peaches from the lemons. This alternative may be helpful for target companies that possess substantial intangible resources and have not yet signaled their value through other means such as prior alliances (Reuer and Shen, 2004).

Selecting the Right Approach

In choosing the best M&A alternative, corporate executives need to take information asymmetries and the risk of adverse selection into account when purchasing other companies or seeking to sell their own company. When faced with these market frictions, decision makers might opt for a joint venture, proceed with an acquisition while writing a contingent contract, or utilize the information disseminated by the IPO market. Managers will likely be unable to eliminate the inefficiencies associated with information asymmetries, but such steps may help deals go through and address overpayment risk on the buyer’s end. Managers also need to be aware of other potential sources of adverse selection risk, including geographic distance and national and organizational cultures. More work remains to be done, however, for researchers and practitioners to gain a more sophisticated understanding of how the informational characteristics of M&As shape investment activity, deal design and corporate performance outcomes.