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Managing M&A Risk with Collars, Earn-outs, and CVRs *

Managing M&A Risk with Collars, Earn-outs, and CVRs *

by Stefano Caselli and Stefano Gatti, Università Bocconi, and Marco Visconti, Merrill Lynch*

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ergers and acquisitions often aim to achieve a strategic transformation of the buyer and target companies, with the expectation of creating

significant shareholder value. But, as a large body of academic research suggests, this expectation is often not borne out. When one considers all the risks that can adversely affect the outcome of the deal, this result is not too surprising. Modern risk management techniques have been developed to help companies manage some of the risks associated with M&A. M&A transactions expose both the bidder and target shareholders to a number of major risks both prior to the close of the deal and during the post-close integration phase. The main pre-closing risk is the possibility that fluctuations of bidder and target stock prices will affect the terms of the deal and reduce the likelihood the deal closes. After the closing, a major risk for bidder shareholders is the failure of the target to perform up to expectations, thus resulting in overpayment. The pre-closing price risks appear to have been enlarged by developments in 2006 that have contributed to stock price volatility worldwide. A number of factors have been

at work here: the stock market pullback from May through July of 2006 (during which the VIX volatility index rose sharply), fears of an imminent U.S. economic slowdown, record commodities prices, increasing concerns about the potential effects of the bursting of the U.S. real estate “bubble,” and an increasingly unstable international politi- cal environment. All these factors have made the valuation of companies more challenging and uncertain. At the same time, 2005 was a record year in terms of M&A activity, with about $2.2 trillion worth of completed deals worldwide. And 2006 is on pace for a new record, with around $1.7 trillion worth of completed deals and $2.2 trillion of announced deals as of the end of August. 1 The combination of price uncertainty and growing pressure on corporate managers to create value through M&A means increased demand for management of both pre-closing price volatility and post-merger performance risk. In this paper, we discuss a number of tools that can

be used to manage risks arising in M&A practice, using actual examples to illustrate the structure and pricing of such tools. As suggested, M&A risks can be divided into two classes: pre-closing and post-closing. In the category of pre-closing instruments, offers with “collars” can provide managers of publicly traded target companies with an effec- tive way out in case of material share price fluctuations. Such instruments can also be used by bidders to cap the payout to selling shareholders (by using “fixed” collar offers) or to limit the dilution of selling shareholders’ claims (using “floating” collar offers) resulting from the deal. Post-closing instruments, which include earn-outs and contingent value rights (or CVRs)—can be used to manage the risk of substandard performance and the overpayment that would result from underperformance. When viewed as an “add on” to upfront payments in cash or stock, earn- outs can also be used to increase the total consideration paid to private sellers, especially in the event of exceptional post-merger performance; and in this sense, they can be viewed as providing sellers with protection against “under- payment.” But perhaps more important, a well-designed earn-out can function as an incentive compensation plan that, in cases involving listed as well as private sellers, retains and motivates key managers. Besides strengthening target managers’ incentives to perform after the deal closes, earn- outs also provide an effective way to bridge the valuation gap in acquisitions involving private, typically fast-growing target companies with limited track records. 2 CVRs are used by listed companies when attempting to take over other public targets. They provide the bidder’s management with financial flexibility and the ability to customize their offers to the target shareholders’ prefer- ences. CVRs are themselves often listed instruments that, although easier to structure than earn-outs, can lead to higher than expected cash outlays if not set up carefully. Moreover, they leave the bidder exposed to general risks, such as adverse stock market conditions (e.g., a high volatil- ity environment, or negative macro developments). In one of his recent books on M&A, Robert Bruner

* The authors would like to thank Avanhidar Subrahmanyam, Ajay Subramanian, Yakov Amihud, Bill Megginson, Enrique Arzac, Ian Cooper, Jason Draho, Adam Shepard, and Don Chew (the Editor) for helpful comments and suggestions on various drafts of the paper.

1. According to the Thomson Financial M&A Database.

2. As discussed later in the article, Ebay’s acquisition of Skype Technologies, which

was announced on September 12, 2005, involved an earn-out with estimated worth of

as high as $1.5 billion.

reported that of all U.S. deals closed between 1992 and 2000, only 1.2% involved the use of earn-outs, while even fewer (0.6%) involved the use of collars (though, in the case of collars, the rate of usage jumps to almost 6% for deals larger than $1 billion). 3 Such low percentages suggest that risk management tools may offer significant untapped potential for adding value in M&A deals.

Pre-closing Risk Management: Collar Offers Stock price volatility has always been a problem in M&A deals, particularly those involving two listed companies that are structured as stock-for-stock swaps. In many such cases, the pre-closing price risk has been hedged using plain vanilla equity derivatives, such as call and put options. In all- cash acquisitions of listed companies, the bidding company can protect itself against a post-offer jump in the value of the target company’s shares by acquiring call options on the shares and then capping its acquisition payment at the weighted average strike price of the options acquired. At the same time, the target company’s shareholders can acquire put options on their shares or, if the transaction is stock- financed, they might hedge their exposure by acquiring put options on the bidder’s stock. 4 These risk management techniques allow their users to hedge price risk effectively, but they do not account for the possibility that one (or both) of the companies might lose interest in the deal if the stock prices of the companies involved change materially from the prices assumed in the agreed-upon transaction price. M&A practice has devel- oped a particular kind of contingent offer, called a “collar offer,” that provides counterparties of a stock-for-stock deal with the option to walk away from the deal if the bidder stock price falls below a certain level (as in a fixed-collar offer) or the ratio of the bidder’s to the target’s stock price moves outside a pre-specified range (as in a floating-collar offer). If the ratio falls below the lower or rises above the upper bound of the collar, an option to abandon comes into effect (also known as a “sudden birth” option) that can be exercised by either counterparty. 5 The upper bound protects

the bidder company’s shareholders from overpayment in fixed-collar offers, or against shareholder dilution in float- ing-collar offers. Meanwhile, the lower bound protects the target company’s shareholders from the effect of a reduction of the bidder’s share price in fixed-collar offers, and from a reduction of their ownership stake in the combined entity in floating-collar offers.

Fixed-collar Offers In stock-financed transactions between listed companies, fixed-collar offers specifically address share price volatility for the companies involved in the deal. This begins with a pre-negotiation of the exchange ratio (for example, two shares of the bidding company for each share of the target company, or 2:1) that will be used in the transaction, and an agreement on a trading collar for the bidder share price. For example, if the bidder’s share price during the nego- tiations is around 10, the parties might agree to a collar that ranges between 9 and 11, which effectively estab- lishes an acceptable range of values for the target from 18 to 22. Should the bidder company’s share price go below 9 or above 11, either bidder or target would have the right to cancel the deal (see Figure 1). 6 The lower bound (9) protects the target company by allowing its shareholders to cancel the transaction if the bidder company’s share price falls below the specified threshold, or, in other words, when the medium-of-exchange value decreases. The upper bound (11), meanwhile, protects the bidder company’s sharehold- ers by limiting the effective purchase price to 22 if market conditions make the transaction unattractive at the pre- negotiated exchange ratio (2:1 in our example). 7 When the two companies in the deal are negotiating to fix the levels of the two bounds, they should keep in mind a well-documented phenomenon affecting M&A announce- ments. Soon if not immediately after the announcement of a transaction, both bidder and target shares experience stock returns that, on average, are significantly positive for the target and range from zero to slightly negative for the bidders. 8 Any expected negative reaction to bidders is likely

3. See R. Bruner, (2004), Applied Mergers & Acquisitions (John Wiley and Sons).

4. An example is the recently announced Telecom Italia–T.I.M. merger, in which about

50 million options were negotiated by the parent company Telecom Italia to manage the

risks associated with the tender offer launched on T.I.M. shares. The company acquired 25

million American call options (expiration date, January 31, 2005), entitling it to buy up to

50 million T.I.M. ordinary shares and up to 25 million non-voting shares; at the same time,

Telecom Italia entered into an agreement to sell up to 25 million put options on the same amounts and classes of shares (Telecom Italia December 21, 2004, press release).

5. A sudden birth (or sudden death) option is an option whose existence (or expira-

tion) is contingent on a condition; if the condition is met, the option comes into existence (or expires). The most common conditions involve the underlying asset price reaching negotiated thresholds moving upward (up-and-in, up-and-out) or downward (down-and- in, down-and-out).

6. Technically this option resembles a sudden-birth barrier exchange option—one that

allows each counterparty to cancel the transaction by exchanging the share amounts indicated in the pre-negotiated exchange ratio, only in the opposite direction. With an exchange ratio of n:1 (2:1 in our example), the target company’s shareholders could exchange n (2) of the bidder company’s shares for one of their own shares. See K.P. Fuller, (2003), “Why Some Firms Use Collar Offers in Mergers,” Financial Review, Vol.

38 (1), pp. 127-150, and M. Officer, (2004), “Collars and Renegotiation in Mergers and Acquisitions,” Journal of Finance, Vol. 54, pp. 2719-2740.

7. Fuller (2003) argues that the collar might be interpreted as a particular form of a

Material Adverse Change (MAC) clause. However, market evidence does not seem to confirm this argument, both because MAC clauses exist independently of the collar in collar offers, and because they look more like a renegotiation point, rather than a nego- tiation break-off. Moreover, a MAC clause has a much broader scope, while collar offers define conditions only on the bidder company’s share price or exchange ratio. In both

cases, as we will explain later, the conditionality relates to the total consideration paid to the target company.

8. For an excellent review of empirical studies focused on the effects of M&As on bid-

der and target shareholders’ wealth, see Robert Bruner, “Where M&A Pays and Where It Strays: A Survey of the Research,” Journal of Applied Corporate Finance (Fall 2004); S. Chang, (1998), “Takeover of Privately Held Targets, Methods of Payment, and Bidder Returns,” Journal of Finance, Vol. 50, pp. 773-784; M. Mitchell, T. Pulvino, and E. Stafford, (2004), “Price Pressure Around Mergers,” Journal of Finance, Vol. 59, pp. 31- 63. For implications in an option pricing perspective, see A. Subramanian, (2004), “Option Pricing on Stocks in Mergers and Acquisitions,” Journal of Finance, Vol. 59, pp.

795-829.

Figure 1

Payoff Structure for a Typical Fixed Collar Offer as a Function of Bidder Company Share Price at Closing

When the bidder share price falls between the lower and upper bound (9 and 11, respectively, in our example), the transaction is settled at the pre-negotiated exchange ratio (2:1 in the numerical example). This implies that in such a case the cash value of total consideration received by the target shareholders is a linear function of the bidder company share price. Outside of the two bounds, the exchange ratio is free to float, guaranteeing a fixed cash amount to the target shareholders; even more importantly, the abandon option becomes exercisable.

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to be magnified by the activity of institutional investors, such as M&A arbitrage hedge funds, that try to profit by both buying the target company’s shares to push up their price and selling—often short-selling—the bidder compa- ny’s shares to depress their trading price. If a symmetric collar is negotiated with respect to the bidder’s pre-announcement price—that is, the current stock price is at the same distance from each bound—then the two companies’ shareholders are likely to be similarly protected. But if the market is expected to respond negatively to the announcement of the deal, the collar should be shifted downward to align it with the post-announcement (not the pre-announcement), bidder’s share price, thus guaranteeing the expected level of protection to the bidder company.

Building Expectations Into a Fixed-price Collar One way to incorporate the effects of negative abnormal stock returns (ARs) into a model of abandonment option pricing is to use Black-Scholes or Monte Carlo simulations with a lower current share price for valuation input. Alter-

natively, using the binomial trees approach, it is possible to define a higher probability for the down parameter used in the simulation. Paths “a” and “b” in Figure 2 illustrate the effects of incorporating negative ARs into the simula- tion of a future share price, using a lower starting point. In this case, the collar would be aligned to the post-announce- ment, not pre-announcement, bidder share price. In path b, the probability that the share price will break the lower bound at closing increases from 16% in path a to 28%. The upper bound is violated in path b in only 14% of the simulated outcomes, as compared to 20% for path a. Although the presence of negative ARs can be accounted for in different ways, this result is consistent with our argument: if significant ARs are expected, they will affect the level of protection provided to the two counterparties.

Floating Collar Offers Floating collar offers differ from fixed collar offers in that the exchange ratio is free to float, although only within a negoti- ated range of values. For example, in the deal just discussed

Figure 2.a

Possible future paths followed by a stock price that equals 10 at present, based on Monte Carlo simulations. A collar (9-11) is also shown by the two parallel horizontal lines.

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where the exchange ratio of bidder to target shares is set at 2:1, let’s assume that the ratio is now allowed to float as low as 1.82 (but no lower) and as high as 2.22. In this kind of transaction, provided the ratio stays within the bounds of 1.82 and 2.22, the target company shareholders are guaran- teed a constant euro price per share (20 in this case). 9 But if the ratio moves above or below those bounds, as shown in Figure 3, the price per share paid will be a linear function of the bidder company’s share price, with a slope equal to the exchange ratio upper bound (2.22 in our example) if the upper bound is violated, or equal to the lower bound (1.82) if the lower bound is crossed. The upper bound, as can be seen in Figure 4, allows the bidding company’s shareholders to avoid a material dilution if the bidder company’s share price should fall sharply in the period between when the board sets the cash amount for each target company’s share and when the transaction is actually closed. The lower bound guarantees that the target company’s shareholders will receive at least a pre-deter- mined percentage of merged entity shares (in the example in Figure 4, at least 21.4%).

The AIG-AGC merger The recent merger of AIG and AGC exemplifies how collar structures can be used to manage price risks before a transac- tion is closed. In 2001, facing competition from Prudential

Figure 2.b

Possible future paths of the same stock as in Figure 2.a when ARs are accounted for, as a reduction in the share price at time zero (9.5 instead of 10.0). A collar (9-11) is also shown by the two parallel horizontal lines.

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UK in a takeover of U.S.-based insurer American General Corp (AGC), the U.S. insurance company American Inter- national Group (AIG) proposed a counteroffer for AGC’s shares. AIG’s proposal was structured as a floating collar offer, with the exchange ratio of the transaction allowed to fluctuate between 0.5462 and 0.6037 over an agreed-upon period before the transaction closing. This offer enabled AIG to guarantee AGC’s shareholders a price of $46.00 for each share in the offer, provided AIG’s share price stayed between $76.20 and $84.20. If the price moved outside these bounds, the exchange ratio would be 0.5462 for an AIG share price above $84.20 or 0.6037 for an AIG share price below $76.20. Just before its floating collar offer was launched (after the close of trading on April 3, 2001), AIG’s shares last traded at $80.21, roughly the midpoint of the collar fluctuation range. The floating collar allowed AIG to top Prudential UK’s offer, a fixed collar offer whose value at the time of AIG’s bid stood at $39.00, representing just a 6% premium over AGC’s April 3 closing price of $36.80. By comparison, AIG’s offer amounted to a 25% premium for AGC’s share- holders. What’s more, the use of the floating collar allowed AIG to manage its dilution risk, giving AGC’s shareholders a significant potential upside. To the extent AIG share price moved above $84.20 prior to the close, the lower bound on the exchange ratio would have given AGC’s shareholders the benefits of a further appreciation of AIG shares. The

Figure 3

Floating Collar Offer Payoff Structure.

When the exchange ratio calculated at current market value falls between the lower and the upper bound at closing, the total consideration paid is fixed (horizontal segment). Outside the two bounds, the total consideration is a linear function of the bidder company share price, with a slope equal to the exchange ratio implied in the violated bound.

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Payoff at Closing

Figure 4

Floating Collar Offer Shareholding Structure.

The stake obtained by the target company’s shareholders in the merged entity as a function of the exchange ratio used in the transaction. The constant cash amount has been assumed to be 20 for each target company’s share, while the bidder company share price ranges from 9 to 11. The number of bidder company shares outstanding is assumed to be 100 million. The target company’s shares outstand- ing are assumed to be 15 million. Lower and upper bounds are assumed to be 1.82:1 and 2.22:1, respectively. Given the particular pay- ment structure, in this transaction the target company shareholders’ stake in the combined entity ranges from 21.4% to 25%, correspond- ing to a 1.82:1 and to a 2.22:1 exchange ratio, respectively. Within the two bounds, cash consideration paid is fixed at 20 per share.

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Table 1

Summary of Payoffs for the Two Collar Offers Described

Fixed Collar Offer

Bidder Stock Price at Closing

Payoff

at Closing

Transaction

Exchange ratio

Floating Collar Offer

Bidder Stock Price at Closing

Payoff

at Closing

Transaction

Exchange Ratio

 

8.0

18.0

2.25

8.0

17.8

2.22

8.2

18.0

2.20

8.2

18.2

2.22

8.4

18.0

2.14

8.4

18.6

2.22

8.6

18.0

2.09

8.6

19.1

2.22

8.8

18.0

2.05

8.8

19.5

2.22

Lower Bound

9.0

18.0

2.00

9.0

20.0

2.22

Upper Bound

 

9.2

18.4

2.00

9.2

20.0

2.17

9.4

18.8

2.00

9.4

20.0

2.13

9.6

19.2

2.00

9.6

20.0

2.08

9.8

19.6

2.00

9.8

20.0

2.04

10.0

20.0

2.00

10.0

20.0

2.00

10.2

20.4

2.00

10.2

20.0

1.96

10.4

20.8

2.00

10.4

20.0

1.92

10.6

21.2

2.00

10.6

20.0

1.89

10.8

21.6

2.00

10.8

20.0

1.85

Upper Bound

� 11.0

� 22.0

2.00

� 11.0

� 20.0

1.82

Lower Bound

 

11.2

22.0

1.96

11.2

20.4

1.82

11.4

22.0

1.93

11.4

20.7

1.82

11.6

22.0

1.90

11.6

21.1

1.82

11.8

22.0

1.86

11.8

21.5

1.82

12.0

22.0

1.83

12.0

21.8

1.82

upper bound, meanwhile, limited the extent to which the voting power of AIG’s shareholders could be diluted in the combined entity. Finally, the collar in AIG’s counteroffer allowed the company to make a more attractive pure stock offer than Prudential UK by reducing the target shareholders’ uncertainty about the value of the shares being offered in exchange. During the battle for control, the UK insurer’s shares fell by over 30% (between January 2, 2001 and April 3, 2001); and since the proposed exchange ratio for Prudential’s offer was fixed at 3.6622, the drop in the value of its shares reduced the effective premium it was offering for AGC, making AIG’s offer all the more attractive. As the result shows, AIG managed the merger quite effec- tively. The day after AIG announced its counteroffer, the value of its shares dropped to around $76. But the floating collar enabled AIG to keep the transaction equally attractive to AGC’s shareholders since the exchange ratio increase fully compensated them for the decrease in the value of the shares. The transaction closed on August 29, 2001 within the float- ing collar bounds, at an exchange ratio of 0.5790. And despite

the market’s initial negative reaction, the deal has proved to be positive for AIG’s shareholders, as can be inferred from the quick rebound in AIG share price following its drop after the announcement. Just two weeks after the launch of the deal, AIG’s stock price had returned to its pre-announcement level, closing above $80 on April 18th.

Recommendations to Bidding and Target Companies From a management standpoint, it is clear that the described contractual structures have the potential to offer a signifi- cant competitive advantage in a takeover battle. As recent papers have highlighted, the negotiation of a collar repre- sents a cost for the bidder’s management in terms of the complexity of the offer structure and the time and effort required for the negotiations. 10 The justification for bear- ing this cost is the expected value of the reduction of the negotiation costs; should the collar be violated, the transac- tion could immediately be cancelled by either counterparty with no need to resort to material adverse change clauses

Table 2

Fixed vs. Floating Collar Offers: Pros and Cons

Company

Bidder

Target Company

Fixed Collar Offers

Floating Collar Offers

Pros

Cons

Pros

Cons

Dilution risk minimized (pre-negotiated exch. ratio)

• Price risk management sub-optimal in presence

• Perfect risk management of the cash value of the

Abandon option outside

• Sub-optimal dilution risk management

• Simpler to negotiate vs. floating collar offers

Abandon option outside of negotiated bounds

of small relative move- ments of bidder vs. target

share prices

consideration paid

of negotiated bounds

• Achievement of a pre-negotiated interest in the bidder company

• Abandon option outside of negotiated bounds

• Price risk management sub-optimal in presence of small relative movements

of bidder vs. target share prices

• Guaranteed cash value of the medium of exchange

Abandon option outside of negotiated bounds

• Uncertainty regarding the pro-forma ownership structure

(MACs) or similar measures, which are often unsuccessful. The existing literature on market practice reveals that collar offers are used more frequently in the finan- cial services industries, especially in the banking industry, largely because regulatory capital requirements favor the use of stock as a means of payment. In particular, float- ing collar offers provide the target shareholders with greater certainty about the per share payment, while at the same time preserving the financial flexibility of the bidder. Interestingly, empirical analysis suggests that the use of collars has the effect of reducing the negative abnormal stock returns (ARs) typically experienced by bidders in stock-for-stock offers. More specifically, studies suggest that the ARs are the most negative in the case of pure stock- for-stock offers, less negative for fixed-collar offers, still less negative for floating-collar offers, and typically positive in the case of all-cash offers. 11 These findings suggest, among other things, that a floating-collar offer is interpreted by the market as a signal of the bidder’s management’s confidence in its company’s value. By effectively managing dilution and overpayment (and underpayment) risks, a collar offer allows the bidder’s management to be more aggressive in its pricing of a stock- for-stock deal and hence be a competitive player in a battle for control. A fixed collar offer is more attractive when target shareholders are willing to accept a certain amount of uncertainty about the consideration received. Floating

collars, by contrast, are likely to be more effective when dealing with a significantly risk-averse (e.g. retail) investor clientele, since they effectively guarantee a fixed price per share provided the bidder’s price stays within the specified range (and if it doesn’t, the two counterparties have the option to cancel the deal).

Dealing with Post-merger Uncertainty:

The Use of Earn-outs Although collar offers can have significant benefits in a competitive bidding environment and reduce overall trans- action costs, they offer no protection against the possibility that the target will fail to live up to expectations after the deal closes. Should the two integrated companies fail to realize most of the expected synergies, the bidder company will likely have overpaid for the target. M&A practice has developed two main instruments to manage performance risk in the integration (or post-closing) phase: earn-outs and contingent value rights. A number of studies have documented the poten- tial importance of asymmetric information and moral hazard in M&A transactions. 12 To the extent the target company’s insiders (managers or shareholders) have better information about their company, they can value it more accurately than the bidder’s management. 13 Furthermore, the target’s insiders will sell at a price no less than the fair value of the company; and given the uncertainty about a

11. Ibid.

12. See, among others, R. Roll, (1986), “The Hubris Hypothesis of Corporate Take-

overs,” The Journal of Business, Vol. 59, pp. 197-216; R.G. Hansen, (1987), “A Theo- ry for the Choice of the Exchange Medium in Mergers and Acquisitions,” The Journal of Business, Vol. 60, pp. 75-95; J. Houston and M. Ryngaert, (1997).

13. See S. Myers and N.S. Majluf, (1984), “Corporate Financing and Investment Decisions when Firms Have Information Investors Do Not Have,” Journal of Financial Economics, Vol. 13, pp. 187-221; B.E. Eckbo, R. Giammarino, and R. Heinkel, (1990), “Asymmetric Information and the Medium of Exchange in Takeovers: Theory and Tests,” Review of Financial Studies, Vol. 3, pp. 651-675.

The Saeco Tender Offer

consisted of two parts: a performance plan and an incentive loyalty plan. According to the performance plan, in the event of a merger between the offering vehicle (Giro Investimenti I) and Saeco, three of the Saeco’s selling shareholders, with a combined stake of 52% in the company—were entitled to a variable payment ranging from 1.0 million to 6.0 million. The payment was a function of the merged entity’s con- solidated EBITDA for the year ending on March 31, 2005. In particular, the 1.0 million payment was contingent on EBITDA being above 120.0 million, and would increase linearly up to 6.0 million should EBITDA reach 130.0 million, after which it was capped. 17 The loyalty incentive plan, although similar to the performance plan, added an important clause—one that

79.7 million. To address these issues, the selling sharehold- effectively matches the payment from the performance plan,

ers and the acquiring vehicle negotiated an earn-out clause as part of the shareholders’ agreements, which effectively

provided only that, as of September 30, 2005, all of the above managers are still with the company. 18

was necessary for Saeco to compete effectively in the future. Second, Saeco’s profitability had to be restored. Its EBITDA margin had dropped from around 27% in 2002 to 19% in 2003, and EBITDA had fallen from 110.0 million to

I n March 2004, Paribas Affaires Industriels Private Equity Funds, through the controlled companies El Gringo Investimenti, Giro Investimenti, and Giro Investi- menti I, acquired a 67% stake in Saeco S.p.A., the leading Italian manufacturer of espresso coffee machines, from the company’s controlling shareholders. As required by Ital- ian law, after control of Saeco changed hands, a tender offer was launched for all of Saeco’s remaining outstand- ing shares. The acquisition involved significant issues. For one thing, the company needed to retain key managers whose expertise

the company needed to retain key managers whose expertise target company’s fair value, sellers can exploit

target company’s fair value, sellers can exploit their infor- mation advantage by accepting an overvalued offer. The potential moral hazard problem refers to the actions—or in some cases the inactivity—of the target company’s management in the post-merger phase. If a company’s success depends critically on valuable human capital, an M&A transaction with such a company is riskier because those people could leave. 14 To reduce this risk, it might be necessary to offer current managers incentives to remain active in the target’s management. These problems of information and incentives repre- sent barriers to M&A deals, and the greater the uncertainty about the target’s fair value—whether due to asymmetric information or moral hazard—the more likely that counter- parties will look for risk management solutions. Earn-outs allow the parties to limit the effects of such uncertainty by dividing the payment into two tranches. 15 The first tranche is certain to be paid out, and is usually settled at the closing of the transaction. The second tranche will be paid at a future date only if certain conditions, negotiated in the present, are met. The second payment tranche is typically tied to the target company’s future performance.

The likelihood of using an earn-out contract depends on how much uncertainty there is about the target compa- ny’s true value. Although synergies can be an important consideration, the valuation of the target will often depend heavily on the target’s future expected performance as a stand-alone entity. By structuring the deal with an upfront payment plus an earn-out, acquirers can reduce the risk of mispricing the target company to the point where their only risk is that the cash consideration paid at the closing exceeds the target company’s fair value plus realized synergies. One potential benefit of earn-outs is their effectiveness as a self-selection mechanism. Target managements are likely to accept—and in fact they are even likely to propose—a deal with an earn-out only when they are convinced of their companies’ ability to meet the conditions that trigger the second set of payments. 16 Low-quality companies would be reluctant to accept such payment structures since the management knows that the contingent tranche has a low probability of being paid in the future. In sum, the earn- out provides a self-selection mechanism that addresses both the asymmetric information and moral hazard problems by (1) enabling companies with uncertain prospects to make

14. See N. Kohers and J. Ang, (2000), “Earnouts in Mergers: Agreeing to Disagree

and Agreeing to Stay,” The Journal of Business, Vol. 73, pp. 445-476.

15. There might be more than two tranches, and they will be either certain or condi-

tional. Therefore, it is possible to categorize payments according to the two characteris- tics above.

16. See R. Bruner, (2001), “Does M&A Pay?,” Darden School of Business and Admin-

istration, University of Virginia.

17. Given the limited value of the earn-out provisions relative to the value of the 52%

stake (a maximum of �12 million vs. about �370 million), the discussed earn-outs appear to be designed primarily to retain the three managers rather than addressing any per- ceived disagreement about the value of the firm. 18. The contract payoff was also contingent on the same EBITDA thresholds as before (with payment ranging from �500,000 for an EBITDA of �120.0 million to �6.0 million for an EBITDA above �130.0 million).

credible statements of confidence in their own future and (2) providing them with strong incentives to back their statements with strong performance.

Some Applications of Earn-outs The special structure of earn-out contracts makes them better suited to high-tech industries or transactions involving non-listed companies that do not have to meet the extensive disclosure requirements of listed companies. To the extent the value of a company depends heavily on intangible assets that are difficult to value, the buyer will want to be protected from a possible misvaluation of those assets. For the target company, the earn-out is an opportunity to cash in on the full value of the company. This is a key concern, especially for small innovative companies that do not have a sufficient track record to prove their real value. Without contingent payment contracts, these companies may have to resign themselves to selling at a discount to their perceived intrinsic value. Earn-outs are also used for companies that depend on a key managerial team. The contract provides an incentive for the target management to remain with the company after the merger. The typical life of an earn-out ranges from two- to five- years after the transaction’s close, with the average being around three years. 19 The payments resulting from an earn-out contract are typically tied to performance figures such as revenues; earnings before interest, taxes, depreciation, and amortization (EBITDA); earnings before interest and taxes (EBIT); and net income. The choice depends greatly on the industry in which the company operates. Research analysts generally focus on particular multiples for each industry that are deemed to be the most meaningful. For some industries, it is enterprise value over EBITDA; in others it’s the more conventional price-to-earnings ratio. One of the key issues relating to the use of earn-outs is the possibility of future lawsuits stemming from problems with accounting transparency and the discretion allowed by GAAP and IFRS in determining accruals and deferrals, depreciation, and provisions. Legal disputes could center on whether or not the target company has reached the perfor- mance targets in terms of EBIT or EBITDA. If the bidder has material control over the merged entity, some expenses, such as R&D, depreciation, amortization, and provi- sions could be allocated to the acquired company, thereby depressing its EBIT (due to D&A and provisions items) or its EBITDA (in the event R&D expense is allocated or owing to transfer prices). And the opposite could happen as well. If the target company remains largely independent,

the company’s management might decide to underinvest in R&D, minimize provisions, or depreciate and amortize assets over longer periods of time. To address the problem created by managerial discretion in accounting, the parties to an earn-out should consider preparing separate sets of statements for the target company, and then appointing a mutually agreed-upon independent auditor to sign off on them. But even so, in cases where target companies remain largely independent after the acquisition, the risk of improper accounting policies and legal disputes over the achievement of the performance targets is likely to be material. A recent example of the use of an earn-out is eBay’s acquisition of Skype Technologies. On September 12, 2005, eBay agreed to pay $2.6 billion for Skype, half in stock and half in cash, plus an earn-out involving a contingent “all-or- nothing” payment of $1.5 billion in 2008 or 2009 in either cash or stock (at eBay’s discretion). The payout was tied to several performance indicators, including aggressive targets for active users, gross profit, and revenues. Skype generated $7 million in revenue in 2004 and was expected to gener- ate $60 million in 2005 and $200 million in 2006. The company had yet to report a profit at the time of the acquisi- tion, but had more than 54 million registered users. With this earn-out having the potential to amount to over 35% of the total possible consideration of $4.1 billion, the eBay acquisition of Skype illustrates the potential value of using an earn-out to bridge the valuation gap in the M&A process. What the case also makes clear, however, is the need for the bidder and the target to keep separate sets of audited statements to determine if the contingent payment should be paid. But despite the associated risks, well-designed earn-outs can be useful tools that bring flexi- bility and value-adding potential to the M&A process.

The Pricing of Earn-outs For pricing purposes, earn-outs resemble options on the target company’s fair value. The target company’s share- holders hold what amounts to a long position in a call option on their company’s value—an option that entitles them to cash in, at the dates negotiated in the contract, some percentage of the difference between the price received at closing and the company’s estimated fair value (assum- ing the latter is higher). The future contingent payment of earn-out contracts is also generally capped at a negotiated level (which implies that the target shareholders sell a call option to the buyer with a strike price higher than the one implied by the initial part of the payment to the bidder company’s shareholders). From that point on, all the excess value generated by the merger accrues to the buyer. The payoff structure of earn-outs thus suggests that they

Figure 5

Simulation of Saeco’s March 2005 EBITDA Levels

Estimated by selling shareholders (blue line) and the bidding company (black line).

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should be valued as options rather than using discounted cash flow (DCF) analysis. And if one uses an option pricing model to value an earn-out, then bidders will aim to reduce the length of the earn-out period (all other things equal) while the target company’s shareholders will seek a longer

contract. 20 This reflects the fact that in an option pricing environment, the longer the tenor of the option, the more likely it is to expire in the money and thus the higher its value. Another consequence of using the option pricing approach to value earn-outs is that high underlying asset variability increases the contract value. But if we instead price earn-outs using a DCF approach, the bidder’s shareholders’ benefit from an increase in the contractual life of the agreement due to the time-value- of-money effect, while the target company’s shareholders prefer earn-outs with shorter tenors to avoid the negative effect of discounting. DCF is probably better suited to pricing cash-or- nothing contingent payments, when a fixed amount must be paid if future conditions are met. Typical examples are

a new product launch or an increase in the market share

of the company. Pricing such payments means assigning

a probability of success to the future conditions, and then

discounting, at the risk-free rate, the contingent payment

multiplied by the probability of success—or, to put it another way, discounting future payments at a rate that includes a failure risk premium. In most earn-out valuations, the key issue that must be addressed is the potential difference in the two compa- nies’ views of the probability that the embedded option will expire in the money. Going back to the Saeco case-study, the earn-out clause entitles selling shareholders to receive a contingent payment only if their estimates of the company’s future performance are realized. It seems clear from the terms of the deal that the bidder’s controlling shareholders were unwilling to bear the risk of valuing Saeco on the basis of a projected 2005 EBITDA above a certain value—in this case, 120.0 million. On the other hand, the willingness of the selling shareholders to defer part of their payment and tie it to the projected EBITDA suggests their confidence in their ability to achieve such profits. Recall that Saeco’s last reported EBITDA for the year ending December 31, 2003 was 79.7 million, represent- ing an EBITDA margin of about 19.0% of total reported 2003 revenues of 419.8 million. Based on this figure, it might seem unlikely that the company will be able to achieve the negotiated threshold of 120.0 million, above which the earn-out produces a payoff. But consider also that

Table 3

Valuation of the Performance Plan and of the Incentive Loyalty Plan

 

Value Estimated by the Selling Shareholders

Value Estimated by the Bidder Company

Earn-out 1:

2.49 million

zero

Earn-out 2:

2.75 million

zero

EBITDA for the year 2002 was 110.0 million, resulting in an EBITDA margin of 26.8%. Given the broad range of possible outcomes indicated by these two figures, the two parties used the flexible, option-like pricing of the earn-out to bridge the valuation gap. When computing the value of such instruments, one can use Monte Carlo simulations to generate the probabil- ity distributions that are especially useful in option pricing applications. Since a payoff from the earn-out will occur only if the option expires in the money (and there is no possibility of a negative payoff), one can estimate the future value of the underlying asset—the merged entity’s EBITDA—using Saeco’s current EBITDA of 79.7 million together with random draws from a triangular distribution. 21, 22 We performed the simulations for EBITDA over the time period between December 31, 2003, the date of the last reported EBITDA, and March 30, 2005, the expiration dates of the two earn-outs. We did so from both the bidder and seller perspectives, assuming that the bidder would use the lower 2003 EBITDA as a basis for forecasting, whereas the seller would use the higher 2002 EBITDA. 23 As can be seen in Figure 5, the difference in the valua- tions obtained by the two parties to the merger is clear. According to the 500 simulations run for the bidder company, at no future point will the negotiated earn-outs produce a payoff. Yet, the target company’s management expects a payoff in 98.8% of possible future scenarios. Assuming a 10% discount rate for selling shareholders, we calculated expected values for the two earn-outs that are shown in Table 3. According to our estimates, selling share- holders expected a payoff from the earn-out of about 5.24 million. At the same time, the bidding company effectively assigns a value of zero to the earn-out portfolio.

As we already noted, these contracts allowed the bidder to manage the variability of the total consideration paid, while limiting the sum of the two contingent payments to 12 million. At the same time, selling shareholders are motivated by the loyalty payment to stay with the company and by the performance-based contracts to contribute to increases in profitability. What’s more, by their willing- ness to enter into a contingent payment contract based on Saeco’s value, the selling shareholders demonstrated their confidence in the value of their company and signaled to the market that the company is a high-quality target. Nevertheless, as has become clear from some recent examples, poorly designed earn-outs have the potential to create unexpected financial burdens for the merged compa- nies. For the managers of the bidder and seller, having a solid understanding of the mechanics of an earn-out, particularly with regard to the pricing and future payments required by such contracts, can be critical to success.

Contingent Value Rights Contingent value rights (CVRs) range from plain vanilla to exotic stock options that are issued in stock-financed M&A transactions. CVRs are used in many transactions, often under different names such as warrants or stock options, and are frequently listed on regulated markets. From a technical standpoint, CVRs are flexible instru- ments that are often structured as “binary” (or “digital”) options that result in all-or-nothing payments. In this case, the instrument payoff does not depend in a linear way on the underlying asset price, but rather involves a bullet payment made either in cash or in stock. In a typical stock payment, the stocks to be assigned under the CVR agreement are issued at the transaction closing and then deposited into an escrow account. Other examples of CVRs negotiated in M&A transac- tions involve exotic options, such as sudden death options (like “up-and-out” puts), where the claim expires without value or payoff if the underlying asset price breaks the collar’s upper bound. To reduce uncertainty, however, the underlying asset is often an average over several trading days and not a spot price. Other CVR structures have upper and lower bounds that are not fixed, but increase over time at a predetermined

21. See Bruner and Stiegler (1999) and Bruner (2004).

22. The random extractions will necessarily fall between a minimum value and a

maximum value. The third parameter that completes the triangular probability distribu- tion is the most likely value (or top value) for the EBITDA growth rate. Monte Carlo simulations are used here over five observations: generally, from one value to the next (namely, two interim reports), there will be a time span of not less than three months. As

a result, we divided the time period over which the derivative is written into five intervals. This allows us to capture the increased uncertainty about future outcomes.

23. The pricing of the two instruments starts from the following hypotheses regarding

the assumptions of the two counterparties: the target company’s management evaluates the contracts from a starting point of 112.5 million for 2003 EBITDA (obtained by ap- plying the 2002 EBITDA margin to the 2003 sales), and then discounts future payoffs at maturity at a certain discount rate, relatively high, to compensate for use of the “high”

2002 EBITDA margin (+8% vs. 2003 margin) as a simulation driver (Bruner and Stiegler, 1999). However, when performing the analysis from the bidder’s perspective, we use the actual 2003 EBITDA figure, a flat margin of 19.0%, to simulate possible future EBITDA values. The minimum, maximum, and top values representing revenue and EBITDA growth (since we assume no change in the EBITDA margin over each quar- ter) from one quarter to the next, are set at 2%, 4%, and 3% for both target and bidder company management.

growth rate. With still others, the instrument tenor can be modified by the parties. Given the vast universe of tailored options available, the CVR’s actual structure will ultimately be determined by the bidder’s management, perhaps in negotiation with the seller. What explains the use of CVRs in M&A deals? One clear factor is the effectiveness of CVRs in protecting target share- holders from drops in bidder stock price. This protection can be provided in the form of either cash compensation or the issuance of new shares by the bidder. Such contracts aim to make a stock-for-stock offer more attractive for target share- holders, without burdening the acquirer’s financial structure with excessive financial leverage. Another explanation for CVRs is their attractiveness to certain kinds of investors. When the target is a public company, the vast majority of shareholders are often finan- cial investors (i.e., mutual funds as well as individual investors) as opposed to other companies. To make the offer as attractive as possible for this category of sharehold- ers, CVRs effectively guarantee the target shareholders a minimum cash value for the stock offered in the transac- tion. This helps reduce the potential for a hostile reaction by target shareholders, who, without the CVRs, might not be willing to tender their shares for those of another company. Even though they have the option to sell the received shares on the market after closing, they might not be willing to look for another investment opportunity. CVRs can address these issues. CVRs can also be used to avoid the cash outlay associ- ated with mandatory tender offers that have to be launched following the change of control over the target company. Interestingly, CVRs can be designed either to encourage or to deter the target company’s financial shareholders from delivering their shares to a tender offer. The CVRs that are used to discourage shareholders from delivering shares to a public offer are typically written on the target company’s shares in order to guarantee a minimum price (e.g. a put option) to all shareholders who keep their shares, thus making those instruments more attractive to them. As in the case of earn-outs, the use of CVRs can have unforeseen and unwanted consequences. For example, a few instruments that were issued near the peak of the U.S. and European stock markets in 2000 resulted in unexpect- edly large payouts by bidder companies at the end of their contractual lives. Hence the need for management to understand how to value these instruments as well as the

potential limitations of option pricing using the standard Black-Scholes model. 24

The Use of CVRs: Two Illustrative Examples In June 1998, the German insurance group Allianz issued CVRs to the shareholders of Assurances Generales de France (AGF) to discourage them from tendering their shares into their offer for AGF. In this friendly take- over, the German company aimed to keep a satisfactory percentage of total AGF shares as free float but, accord- ing to French law, it had to launch a mandatory tender offer for all outstanding AGF shares. To avoid the massive cash outlay needed for such a purchase, Allianz assigned one CVR to each share not delivered to the tender offer, at no charge. The instrument effectively guaranteed its holder, at a future date, a minimum price for each share not tendered. The promised payoff to the holder of this CVR can be viewed as a combination of two exotic put options: a down-and-out put and a down-and-in put. The down- and-out put entitled its owner to receive the difference (if negative) between the future market price of AGF shares and FRF360 at the exercise date (between June 1, 2001 and June 15, 2001) if the AGF price (about FRF 350 at the time of the offer) fell between FRF320 and FRF360. Below FRF320, the option would expire without any payoff (sudden death at FRF320), but the down-and-in put option would come into existence (sudden birth at FRF320). The down-and-in was an exchange put option that allowed the option holder to deliver AGF shares and receive FRF360 per share (see Figure 6). In sum, the combination of puts built into this CVR effectively guaranteed its holders a minimum value of FRF360 at the exercise date. Thanks in part to the CVR offering structure, the offer by Allianz prevailed over a competing bid by the Italian insurer Assicurazioni Generali for 8.0 billion. And besides offering downside protection for some of AGF’s shareholders, the down-and-in put options also protected Allianz in the event of a significant reduction in AGF’s share price. The main reason for using two options with non-overlapping regions was to provide Allianz with the right, in the event the value of AGF’s shares dropped, to acquire all of the portfolio’s underlying shares at the specified exercise date. By encouraging AGF sharehold- ers not to deliver their shares in the tender offer, CVRs

Figure 6

Total Value of the Described Portfolio

(one AGF share plus one CVR) at CVR exercise date

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allowed Allianz to limit the total size of the cash outlay at the transaction closing. At the same time, by allowing for what amounted to a selective purchase of the compa- ny’s controlling stake, it made possible an offer valued at

10.5 billion, approximately 2.5 billion higher than the Although the use of M&A risk management instruments

is still relatively limited in international financial markets, recent increases in stock market volatility have increased the likelihood they will be used in the future. We classify such instruments into two categories: (1) instruments for manag- ing “pre-closing” risks, notably the changes in bidder’s stock price that can end up affecting the terms of the deal; and (2) “contingent value” instruments that guard against the risk of overpayment by making the price of the deal contin- gent on post-close performance of the target. In the first category of instruments, collars provide bidder and target companies with a means of limiting dilution and price risk, which in turn reduces ex post negoti- ation costs and gives the managers of both companies an easy way out in case of material share price fluctuations. Post-closing instruments such as earn-outs and CVRs can be used to limit the risks of over- or under-payment and for their tailoring potential, particularly when takeover offers address minority shareholders’ preferences. Earn-outs are likely to be an effective risk management tool in acquisi- tions involving high-growth companies with limited track records and uncertain, if promising, future performance. Earn-outs can also be effective in retaining and motivat- ing a target company’s managers. But if earn-outs provide a way of bridging the valuation gap during negotiations for a takeover, they have a number of limitations, including the difficulty of pricing them, the expense of negotiating them, and their vulnerability to legal dispute.

a value of about 51.0 for Equant shares, which represented

about 2 billion (i.e., 15 per each CVR) at the expiration of the CVRs.

Conclusions

Generali bid. CVRs can also be used to protect target shareholders from downside risk when a tender offer is not launched for all the target shares; that is, when a controlling stake is acquired in a private transaction outside the stock exchange and there is no legal obligation to launch a mandatory tender offer. In 2000, for example, France Telecom (FT) acquired a controlling stake in Dutch telecommunications carrier Equant NV by purchasing (on the stock exchange) the 34% stake held in the company by the Sita Foundation. FT acquired Sita’s 34% stake by exchanging one of its own shares for 2.2 Equant shares. At FT’s current market price, this exchange ratio implied

a 37% premium over its pre-transaction price of about 37. To make the transaction more attractive to Equant’s minor- ity shareholders, FT announced at the same time that it would grant one CVR to each Equant share not previously held by Sita. The rationale for this transaction was to give Equant minority shareholders downside protection. Each CVR effectively entitled Equant shareholders to sell one share to FT for 60 three years after the closing, provided Equant’s price remained 45 or higher (thus effec- tively capping the payout on each contract payout at 15). Because Equant’s price ended up below 45 at the end of the three-year period, the CVRs issued by FT to Equant’s minority shareholders resulted in a cash outlay by FT of

CVRs, by contrast, are better suited to companies engaged in competitive bidding to take over public targets, providing the bidder’s management with greater financial flexibility and significant potential for tailoring their offers. They are easier to structure as instruments than earn-outs; and because they are often listed, CVRs are probably most suitable when both bidder and target companies are listed. Like earn-outs, CVRs can be used to encourage target share- holders either to deliver or to retain their shares (in selective purchases). But, unless carefully structured, they can lead to higher than expected cash outlays while leaving their issuer exposed to volatile macro and stock market conditions.

stefano caselli is Associate Professor of Banking and Finance at Università Bocconi Milan and Director of Customized Programs in Bank- ing and Insurance Firms at SDA Bocconi School of Management.

stefano gatti is Associate Professor of Banking and Finance and Director of the BSc in Economics and Finance at Università Bocconi, Milan.

marco visconti is a European equity sales trader at Merrill Lynch in Milan.