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Signaling and risk allocation in merger agreements

Antonio J. Macias* Thomas Moeller**

Abstract Acquirers and targets allocate interim risk in merger agreements through Material Adverse Change (MAC) clauses and exclusions. While virtually all acquisitions have MAC clauses, there is broad cross-sectional variation in the number and type of MAC exclusions. Using comprehensive hand-collected data, we find that acquisitions with fewer firm-specific MAC exclusions, i.e., stronger abandonment options for the acquirers, are associated with higher acquirer announcement returns, higher combined surplus gains, higher target announcement returns, and better prior target performance. Fewer firm-specific MAC exclusions appear to be credible signals of higher target quality and are more prevalent when information asymmetries are likely high and signaling is particularly beneficial. In contrast, more market-wide MAC exclusions are not associated with higher acquirer or target gains although acquirers tend to assume the largely exogenous, market-wide interim risk when the expected completion periods are longer.

Keywords: Mergers, acquisitions, signaling, material adverse change clauses and exclusions JEL classification: D86, G14, G32, G34 This draft: April 2013 * Texas Christian University, TCU Box 298530, Fort Worth, TX 76129. E-mail: a.macias@tcu.edu, phone: 817.257.5962 ** Texas Christian University, TCU Box 298530, Fort Worth, TX 76129. E-mail: t.moeller@tcu.edu, phone: 817.760.0050

Signaling and risk allocation in merger agreements

Abstract Acquirers and targets allocate interim risk in merger agreements through Material Adverse Change (MAC) clauses and exclusions. While virtually all acquisitions have MAC clauses, there is broad cross-sectional variation in the number and type of MAC exclusions. Using comprehensive hand-collected data, we find that acquisitions with fewer firm-specific MAC exclusions, i.e., stronger abandonment options for the acquirers, are associated with higher acquirer announcement returns, higher combined surplus gains, higher target announcement returns, and better prior target performance. Fewer firm-specific MAC exclusions appear to be credible signals of higher target quality and are more prevalent when information asymmetries are likely high and signaling is particularly beneficial. In contrast, more market-wide MAC exclusions are not associated with higher acquirer or target gains although acquirers tend to assume the largely exogenous, market-wide interim risk when the expected completion periods are longer.

More than half of acquirers experience negative announcement returns (Andrade, Mitchell, and Stafford, 2001) and some acquisitions are associated with large wealth destruction (Moeller, Schlingemann, and Stulz, 2005). These poor outcomes for acquirers are initially surprising because, through so called Material Adverse Change (MAC) clauses, acquirers can protect themselves from being forced to consummate acquisitions of materially flawed targets that experience material reductions in value. Yet, while virtually all acquisitions have MAC clauses, there is substantial variation in MAC exclusions. MAC exclusions limit the breadth of MAC clauses and thereby restrict the acquirer’s ability to walk away from an acquisition.1 Using comprehensive hand-collected data, we exploit the variability of MAC exclusions to study their determinants and effects on acquirers’ and targets’ acquisition gains. Deals can have few MAC exclusions for at least three reasons. First, acquirers with strong bargaining power can “force” targets to accept deals with few MAC exclusions, giving acquirers more flexibility to terminate deals in case of MACs. Few MAC exclusions resulting from such circumstances should benefit the acquirers at the expense of the targets. Second, acquirers can offer higher takeover prices in return for fewer MAC exclusions. In such cases, there should be no relation between the number of...
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