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The Use of Escrow Contracts in Acquisition Agreements Sanjai Bhagat (Univ. of Colorado - Boulder) Sandy Klasa (Univ. of Arizona) Lubomir P. Litov (Univ.

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Presentation on theme: "The Use of Escrow Contracts in Acquisition Agreements Sanjai Bhagat (Univ. of Colorado - Boulder) Sandy Klasa (Univ. of Arizona) Lubomir P. Litov (Univ."— Presentation transcript:

1 The Use of Escrow Contracts in Acquisition Agreements Sanjai Bhagat (Univ. of Colorado - Boulder) Sandy Klasa (Univ. of Arizona) Lubomir P. Litov (Univ. of Arizona & WFIC, Univ. of Pennsylvania) September 2014

2 2 Escrow Contracts in Acquisition Agreements -A form of contingent payment contract, where buyer and seller agree that seller will deposit a fraction of purchase price (usually 12.2% of it) into a treasury account for a certain period of time (usually 17.4 months). -Employed in private firm and subsidiary acquisitions but not used in acquisitions of publicly traded targets. -In our sample, escrow accounts used in 52.1% of all unlisted target deals. -More commonly used in (i) stock purchase acquisitions and (ii) acquisitions of stand-alone targets.

3 3 Use of Escrow Contract Funds - EBITDA & Purchase Price Adjustments. - Working Capital Adjustments (A/R, A/P, Inventory, other current assets). - Environmental Liabilities. - Pending Litigation. - Obligations Related to Collective Bargaining Agreements. - Unpaid Taxes Due. - Certain Other Non-Fraudulent Breach of Representations & Warranties. Escrow Agreement Disputes Resolution - Binding Arbitration. - Non-binding Mediation. Escrow Agreements vs. Transaction Insurance - Insurance more expense, and limited in coverage. Institutional Detail

4 4 Preliminary Sample Statistics Variable All Sample (943 obs.) Percent of Deals with an Escrow Agreement 52.1% Variable Escrow Contract (491 obs.) Percent Deposited Through an Escrow Agreement 12.2% Average Escrow Agreement Size (US$ m)$11.7 Average Escrow Agreement Duration (Months)17.4 All Deals Sample Deal with Escrow Contract Percent of deals with:All Sample with Escrow Contracts Sample without Escrow Contracts % Stock Purchases73.7%80.0%66.8% % Asset Purchases26.3%20.0%33.2% % Stand-alone Targets60.30%75.60%43.80% % Subsidiary Targets39.70%24.40%56.20%

5 5 Example -Syntax-Brillian & Vivitar Stock-for-stock Merger; - Escrow Agreement Duration: 12 months; -Escrow Agreement Size: 15% of transaction value; - Target Value: $26M; - SEC Docs: LinkLink (escrow agent) (cap on liability) (claims process) (seller)

6 6 Main Hypothesis The use of escrow contracts in unlisted target acquisitions is an efficient contracting mechanism that: 1)Facilitates completion of these acquisitions by allowing buyers & sellers to manage acquisition-related transaction risks, and 2) Allow parties to overcome information asymmetry problems. Hypotheses

7 7 Several implications of the main research hypothesis follow through. Use of Escrow Contracts - Transaction Risk Predictions -Stand-alone targets are likelier to use escrow contract. -Subsidiary targets less likely to use escrow contract. -Larger targets (relative to acquirer) are likelier to use escrow contract. -Targets with dominant shareholders are likelier to use escrow contract (to manage joint & several liability if post-acquisition breach of reps. & warranties). -Stock purchases (as opposed to asset purchases) are likelier to use escrow contract. Hypotheses

8 8 Use of Escrow Contracts - Informational Asymmetry Risk Predictions -Different industry acquisitions likelier to use escrow contract. -Targets w/ higher degree of earnings management likelier to use escrow contract. -Targets in industries w/ higher earnings volatility likelier to use escrow contract. -Targets in industries w/ lower analyst coverage likelier to use escrow contract. -Distressed targets (i.e., w/ lower interest coverage) likelier to use escrow contract. Use of Escrow Contracts – Other Risks Predictions -Escrow contracts are used if reverse insurance, in the form of liability cap limitations (or caps) is included (caps are on average 2.4 times escrow size). Hypotheses

9 9 Escrow agreements are more common when transaction risk is high, i.e., for: -Stand-alone private targets, targets with dominant shareholders, larger targets (relative to acquirer). -Escrow contract use shortens time-to-complete transaction by 35.5-51.0%.35.5-51.0% Escrow agreements are more common if information asymmetry risk is high, i.e., for: -Targets in cross-industry acquisitions, targets w/ high accruals, targets in industries w/ high earnings volatility or low analyst coverage, targets that are financially constrained. Escrow agreements are more common when other risks may be present, i.e.: -If no reverse insurance in form of liability cap limitations (or caps) is included. Main Findings

10 10 Escrow contracts are associated with significantly smaller target discount: - Adoption of escrow agreement increases valuation of a private target (price-to-sales multiple compared to similar public target) by 3.5-6.1%.3.5-6.1% - Valuation impact stronger for stand-alone targets (7.4-9.1%) and weaker for subsidiary targets (0.8-2.2%). Escrow contracts benefit bidder: - For every dollar in escrow contract deposit, market capitalization to bidder shareholders is increased by 89 cents.89 cents - Bidder benefits from reduced losses (due to unrecorded or uncovered target liabilities), reduced information gathering (due diligence) costs, and reduced litigation costs (in case of dispute with target after closing). Main Findings

11 11 Contingent payments Limited literature on contingent payments in private target acquisitions: - Anecdotal evidence in Deal Points studies, 2008-2012 (by American Bar Association). More academic research for such payments in public target acquisitions: - Stock payments - Officer, Poulsen, & Stegemoller (2009). - Earnouts - Kohers & Ang (2000); Datar, Frankel & Wolfson (2001); Cain, Denis & Denis (2011). - However, escrow contracts & earnouts usually address different frictions. - Other - Officer (2004) – collars. - Burch (1996) – lock-up provisions. - Bates & Lemmon (2005) – termination fees. Private Target Discount Officer (2007) – unlisted target discount & liquidity. Prior Literature

12 12 Data Collect Data from a novel database Business Valuation Resources LLC data. - Information on private target financials from 8K, DEF 14A, 10Q, & 10K. Collect data on 943 acquisitions: - Involve private target & public acquirer. - Target value above $25 million. - Completed 1994-2009. - Available information on target financials & consideration structure. We hand collect data on the presence of escrow contracts, caps, & earn outs. Collect data on size, maturity & type of consideration offered in escrow contract. Other: exclusive access to J.P. Morgan Chase escrow services client proprietary data.

13 13 Univariate Sample Statistics Table I. Panel A. Escrow Contracts and Target Price Discount Characteristics. VariableAll Sample (943 obs.) Percent of Deals with an Escrow Agreement 52.1% Average Time to Completion 57.5 days Variable Escrow Contract (491 obs.) Stand-alone Targets (371 obs.) Subsidiary Targets (120 obs.) % Deposited Through Escrow Contract 12.2%13.0%8.9% Escrow Contract Size (US$ m) $11.7$11.9$11.0 Escrow Contract Duration (Months) 17.417.5 17.1 All Deals Sample Deal with Escrow Contract Unlisted Target Price Discount (Means) Discount All Targets -0.243 Stand-alone Private Targets -0.171 Subsidiary Targets -0.333 Targets With Escrow Contract -0.196 Targets Without Escrow Contract -0.289

14 14 Univariate Sample Statistics Table I. Panel B. Target Characteristics. Average Target Characteristics (Medians) All Sample (943 obs.) Sample with Escrow Agreements (491 obs.) Sample without Escrow Agreements (452 obs.) Target Net Sales (in U.S.$ million)48.738.463.7 Target Total Assets (in U.S.$ million)32.224.643.9 Actual Target Price (in U.S.$ million)73.068.180.0 Relative Target Size (to Acquirer)18.4%17.8%18.9% Target Interest Coverage2.901.933.89 Target ROE0.140.160.12 Target ROA0.040.0350.04

15 15 Percent of deals with:All Sample with Escrow Contracts Sample without Escrow Contracts % with Dominant Owner36.70%48.30%24.10% % with Liability Cap73.7%85.3%61.1% % with Stock Payment Only9.0%11.2%6.6% % with Cash Payment Only36.7%31.8%42.0% % with Earnout Contract12.2%13.8%10.4% % with Installment Note11.7%8.8%14.8% Use of Escrow Contracts and Other Deal Characteristics Table II. Panel A. Deal Characteristics. Table II, Panel B. Sub-sample Comparisons. Escrow Deals with row characteristics Escrow Deals without row characteristics Stock Purchase60.5%43.5% Stand-Alone Target65.2%32.1% Dominant Target Owner68.5%42.5% Use of Liability Cap60.3%29.1% Payment is Stock Only64.7%50.8% Payment is Cash Only45.1%56.1% Use of Earnout Contract59.1%52.1%

16 16 Target Industry Distribution (Table III) CodeFama-French Industry Name % Deals w/ Escrow Agreement & Target in Industry % Deals w/ Target in Industry 1Agriculture0.20.5 2Food Products0.81.0 3Candy & Soda0.20.1 4Beer & Liquor0.00.1 5Tobacco Products0.0 6Toys & Recreation0.20.6 7Entertainment1.01.1 8Printing and Publishing2.12.0 9Consumer Goods0.81.1 10Clothing & Apparel1.41.5 11Healthcare3.93.0 12Medical Equipment3.53.0 13Pharmaceutical Products3.74.9 14Chemicals0.81.4 15Rubber and Plastic Products1.01.3 16Textiles0.00.2 17Construction Materials0.81.6 18Construction2.72.4 19Steel Works, Etc.1.71.4 20Fabricated Products0.0 21Machinery2.92.2 22Electrical Equipment1.41.9 23Automobiles and Trucks1.21.1 24Aircraft1.00.9 25Shipbuilding, Railroad Equipment0.60.4 26Defense0.80.4 27Precious Metals0.00.2 (continued)

17 17 CodeFama-French Industry Name % Deals w/ Escrow Agreement & Target in Industry % Deals w/ Target in Industry 28Non-Metallic and Industrial Metal Mining0.00.1 29Coal0.20.1 30Petroleum and Natural Gas2.32.2 31Utilities0.20.6 32Telecommunication3.73.5 33Personal Services1.71.2 34Business Services * 10.310.5 35Computers2.92.5 36Computer Software * 19.113.9 37Electronic Equipment * 8.08.5 38Measuring and Control Equipment3.73.4 39Business Supplies0.8 40Shipping Containers0.00.2 41Transportation2.12.2 42Wholesale4.14.5 43Retail2.53.5 44Restaurants, Hotels, Motels1.2 45Banking0.81.2 46Insurance0.61.5 47Real Estate0.20.3 48Financial Trading1.92.6 49Other0.81.3 Target Industry Distribution (Table III, continued)

18 18 Determinants of Escrow Contract Use in Unlisted Target Acquisitions (Table IV) (Probit Models)Use of Escrow Agreement Variables: All Targets Stand-alone Targets Subsidiary Targets Target is Stand-alone Private Firm0.223 *** (t-stat)(5.68) Indicator for Asset Sale-0.017-0.03-0.003 (0.41)(0.47)(0.05) Relative Size of Target to Acquirer0.019 * 0.021 ** 0.008 (1.66)(2.53)(1.18) Top Quintile Earnings Volatility Target Industry0.009 ** 0.086 ** 0.108 Indicator(2.04)(2.27)(1.20) Low Analyst Coverage Target Industry0.038 * 0.043 * 0.112 ** Indicator(1.79)(1.87)(2.12) Target & Acquirer are in Different Industry0.016 ** 0.041 *** 0.025 (2.48)(2.95)(0.43) Target Accruals0.542 ** 0.515 * 0.799 * (2.15)(1.71)(1.82) Target Interest Coverage-0.079 * -0.069 ** -0.031 (1.88)(2.00)(1.58) Indicator for Target Dominant Shareholder0.161 *** 0.125 *** 0.218 *** (4.51)(2.95)(2.75) Indicator for Use of Liability Caps0.267 *** 0.312 *** 0.228 *** (6.97)(5.53)(3.70) C&I Loan Rate Spread-0.005-0.023-0.073 (0.10)(0.36)(0.73) Ln (Deal Value)-0.046 *** -0.024-0.073 *** (2.78)(1.06)(2.72) % Deals Target Industry Using Escrow Contract0.208 * 0.426 ** 0.046 (1.68)(2.23)(1.21) % Bidder Use of Hybrid Method of Payment0.012 * 0.010 ** 0.047 ** (1.92)(2.08)(2.48) (continued)

19 19 Endogeneity & Instrumental Variables Choice Adoption of escrow contract is endogenous w.r.t. valuation. Need instruments that are both (i) relevant & (ii) exclusive to determine choice of escrow adoption. Two instruments: - Propensity of peer target industry group to use such contracts. - Bidder reputation to use hybrid securities (including escrow contracts). Verify validity of such instruments through series of tests: - Overidentification test (Sargan stat). - Underidentification tests (partial R-squared, F-stat excluded instruments).

20 20 Excluded Instruments: All Targets Stand-alone Targets Subsidiary Targets Percent of Deals in Target Industry that Use Escrow Agreement in the Previous Year0.208 * 0.426 ** 0.046 (t-stat)(1.68)(2.23)(1.21) Indicator Previous Use of Hybrid Securities by Acquirer0.012 * 0.010 ** 0.047 ** (1.92)(2.08)(2.48) Observations837520317 Pseudo R-squared0.2050.2780.358 Escrow Use Reputation proxy Industry proxy Determinants of Escrow Contract Use in Unlisted Target Acquisitions (Table IV)

21 21 Economic Significance of Estimates in Determinants Model Model of Escrow Contract Use Determinants Independent Variables:∆ in Probability Main Determinants Indicator for Use of Caps 26.70% Target is Stand-alone Private Firm 22.30% Indicator for Presence of Dominant Shareholder 16.10% Low Analyst Coverage Target Industry Indicator 3.80% Target Accruals * 3.69% Target & Acquirer are in Different Industry 1.60% Top Quintile Earnings Volatility Target Industry Indicator 0.90% Target Relative Value * 0.64% Target Interest Coverage * -0.22% C&I Spread * -0.93% Indicator for Asset Sale -1.70% Ln (Target Value) * -7.05% Instrumental Variables % of Deals in Target Industry that Use Escrow Prior Year 4.65% Indicator if Bidder Uses a Hybrid Payment in Prior Year 1.20%

22 22 Due Diligence Costs Analysis Bidders use escrow accounts to diminish due diligence costs. No direct proxy for such costs. We proxy for due diligence costs by time-to-deal completion. - Due diligence costs proportionate to time-to-deal completion. We find supporting results using litigation propensity.litigation propensity - Due diligence costs may be direct or indirect. - Inexpensive due diligence may result in future losses & litigation. - We can use litigation as another proxy for such costs. Our findings support hypothesis that escrow contracts diminish due diligence costs.

23 23 Time-to-Deal Completion Analysis (Table V)Table V All TargetsStand-alone TargetsSubsidiary Targets Independent Variables:OLS2SLSOLS2SLSOLS2SLS Escrow Agreement Indicator-20.385 *** -18.714 * -24.175 ** (t-stat)(2.68) (1.71) (1.99) Instrumented Escrow Agreement Indicator -53.841 ** -40.173 ** -21.001 ** (2.57) (2.58) (2.36) Target is a Stand-alone Private Firm0.74015.811 (0.08)(0.74) Acquisition is Considered an Asset Sale0.8350.8740.0972.41410.6018.838 (0.08) (0.01)(0.15)(0.91)(0.70) Relative Size of Target to Acquirer3.2865.6773.9976.273-0.133-3.071 (0.55)(0.91)(0.47)(0.72)(0.01)(0.31) Top Quintile Earnings Volatility Target Industry6.866 ** 8.904 ** 15.416 * 18.900 ** -11.318-14.321 Indicator(2.45)(2.58)(1.76)(1.97)(0.78)(0.95) Low Analyst Coverage Target Industry Indicator23.361 ** 28.635 *** 36.011 *** 39.560 *** 0.7682.102 (2.32)(2.77)(2.87)(2.75)(0.05)(0.12) Target & Acquirer are in Different Industries3.714 *** 0.803-0.8010.17210.641 * 1.210 (2.64)(1.13)(0.13)(0.03)(1.82)(0.70) Target Accruals12.08825.819-23.223-64.08361.00431.847 (0.39)(0.41)(0.57)(1.04) (0.47) Target Interest Coverage (scaled by 1,000)35.99740.26365.24970.5000.6236.413 (0.91)(0.89)(0.91)(0.93)(0.06)(0.42) Indicator for Target Dominant Shareholder-3.554-2.950-11.566-16.6477.439-16.441 (0.54)(0.18)(1.38)(1.19)(0.53)(0.90) Indicator for Use of Liability Cap in Acquisition8.96818.44711.587-10.2848.8420.454 (1.17)(0.75)(1.13)(0.45)(0.78)(0.02) Commercial & Industrial Loan Rate Spread6.5729.39727.010 ** 31.554 ** -14.291-7.426 (0.73)(0.92)(2.13)(2.14)(0.98)(0.42) Ln (Deal Value)11.238 ** 8.4205.9166.50521.079 *** 23.665 *** (2.25)(1.21)(1.19)(1.36)(3.19)(2.86) Observations884837536520348317 Adjusted R-squared0.0860.0900.1330.1320.0340.027

24 24 Unlisted Target Discount We select to study valuation impact for target based on deal-value-to-sales multiple. - Officer (2007) uses deal-value-to-EBITDA multiples. - We do not use such multiples because: * EBITDA could be <0 (for public bidder or private target). * EBITDA defined discretionary across private targets. We calculate discount as ratio of private target multiple to similar public target multiple (net of one). Matching of public to private target counterparts: - Same industry (2-digit SIC). - Within 20% difference ideal size. - Within 36-months window centered on acquisition announcement date.

25 25 Analysis of Unlisted Target Discount Table VITable VI. Panel A. All TargetsStand-alone TargetsSubsidiary Targets OLS2SLSOLS2SLSOLS2SLS Escrow Agreement Indicator0.084 ** 0.126 ** 0.044 * (t-stat)(2.30)(2.35) (1.65) Instrumented Escrow Agreement Indicator 0.202 *** 0.228 *** 0.139 *** (3.16) (3.28) (2.73) Target is a Stand-alone Private Firm0.159 *** 0.197 *** (4.00)(3.82) Acquisition is Considered Asset Sale0.0250.0290.121 * 0.141 ** -0.019-0.009 (0.63)(0.69)(1.94)(2.16)(0.34)(0.16) Relative Size of Target to Acquirer-0.051 *** -0.04 ** 0.0120.019-0.093 *** -0.069 * (2.72)(2.26)(0.18)(0.29)(2.84)(1.79) Target & Acquirer in Different Industries0.070 * 0.0610.0500.0390.088 ** 0.056 * (1.92)(1.60)(0.95)(0.71)(2.47)(1.86) Top Quintile Earnings Volatility Target Industry0.121 ** 0.133 ** 0.187 ** 0.177 ** 0.0600.062 (1.99)(2.15)(2.10)(1.97)(0.67)(0.62) Low Target Industry Analyst Coverage-0.133 * -0.130 * -0.066-0.096-0.203 * -0.222 * (1.93)(1.81)(0.70)(1.00)(1.84)(1.75) Method of Payment is Only Cash-0.011-0.014-0.038-0.0390.0280.020 (0.29)(0.38)(1.63)(1.61)(0.52)(0.35) Commercial & Industrial Loan Rate Spread-0.019 -0.046-0.0130.019 (0.33) (0.24)(0.56)(0.15)(0.19) Ln (Deal Value)0.042 ** 0.039 * 0.0440.0390.046 * 0.060 * (2.23)(1.85)(1.52)(1.32)(1.76)(1.88) Observations 889825530508359317 Adjusted R-squared0.2180.2260.1790.1910.2250.264

26 26 Economic Effects OLS estimate shows reduction by 8.4% in discount (24.3%) to 15.9%. 2SLS estimate shows reduction by 11.0% in discount (24.3%) to 13.3%. Such estimates do not account for claims from escrow fund by bidder after closing. - Escrow Services at J.P. Morgan Chase report average 60% of escrow funds returned to seller. - This implies that 4.9% (=0.4*12.2%) of sales proceeds are kept by bidder. - Reversal in discount is approximately: 3.5% = 8.4% -4.9% (OLS) 6.1% =11.0% - 4.9% (2SLS)

27 27 Economic Effects Estimates higher for stand-alone targets: - discount 17.1%. - reversal 12.6%-14.3% (before deducting funds kept by bidder). - net reversal is 7.4%-9.1% (net of 0.4*13% funds kept by bidder). Estimates lower for subsidiary targets: - discount 33.3%. - reversal 4.4%-5.8% (before deducting funds kept by bidder). - net reversal is 0.8%-2.2% (net of 0.4*8.9% funds kept by bidder).

28 28 Analysis of Unlisted Target Discount: Interactions (Selected Estimates) Table VI. Panel B. OLS2SLSOLS2SLSOLS2SLSOLS2SLS (1)(2)(3)(4)(5)(6)(7)(8) Escrow Agreement Indicator0.079 ** 0.066 0.087 ** 0.089 ** (t-test)(2.52) (1.56) (2.26) (2.35) Instrumented Escrow Agreement Indicator 0.153 * 0.161 * 0.150 * 0.159 (1.68) (1.73) (1.65) (1.48) Target is Stand-alone Private Firm * Escrow Agreement Indicator0.011 ** (2.15) Target is a Stand-alone Private Firm * Instrumented Escrow Agreement Indicator 0.041 ** (2.38) Demeaned Relative Size of Target to Acquirer * Escrow Agreement indicator 0.041 ** (2.18) Demeaned Relative Size of Target to Acquirer * Instrumented Escrow Agreement Indicator 0.016 * (1.69) Top Quintile Earnings Volatility Target Industry * Escrow Agreement Indicator 0.008 (1.09) Top Quintile Earnings Volatility Target Industry * Instrumented Escrow Agreement Indicator 0.016 * (1.83) Low Target Industry Analyst Coverage * Escrow Agreement Indicator 0.027 ** (2.26) Low Target Industry Analyst Coverage * 0.044 ** Instrumented Escrow Agreement Indicator (2.05) Observations889825889825889825889825 Adjusted R-squared0.2170.2290.2180.2300.2170.2280.2180.234

29 29 Analysis of Bidder Announcement Returns (-1 days to +1 days) Table VIITable VII. Panel A. All TargetsStand-alone TargetsSubsidiary Targets OLS2SLSOLS2SLSOLS2SLS Escrow Agreement Indicator0.014 * 0.016 ** 0.014 * (t-stat)(1.92)(1.96) (1.80) Instrumented Escrow Agreement Indicator 0.033 * 0.037 ** 0.019 (1.85) (1.94) (1.57) Target is a Stand-alone Private Firm0.002-0.008 (0.26)(0.83) Acquisition is Considered an Asset Sale0.0060.009-0.015-0.0140.023 ** 0.034 ** (0.79)(1.09)(1.34)(1.01)(2.13)(2.81) Relative Size of Target to Acquirer0.0120.020 ** 0.022 * 0.024 ** 0.0050.020 (1.55)(2.04)(1.77)(1.97)(0.44)(1.18) Target & Acquirer in Different Industries-0.006 * -0.009 ** -0.010 ** -0.012 ** -0.001-0.004 (1.79)(2.24)(2.03)(2.15)(1.05)(1.36) Log(Market Value of Acquirer Assets)-0.004-0.006-0.005-0.007-0.002-0.001 (1.20)(1.41)(0.91)(1.19)(0.42)(0.26) Top Quintile Earnings Volatility Target Industry-0.015-0.017-0.026 * -0.025 * -0.006-0.009 (1.28)(1.34)(1.71)(1.83)(0.36)(0.46) Low Analyst Coverage Target Industry-0.005-0.001-0.014-0.001-0.004-0.021 (0.48)(0.05)(0.96)(0.08)(0.21)(0.93) Method of Payment is Only Cash0.0060.0010.0090.0110.0020.001 (0.88)(0.08)(0.95)(0.09)(0.15)(0.07) Method of Payment is Only Stock0.038 ** 0.041 ** 0.046 ** 0.049 ** -0.006-0.020 (2.29)(2.33)(2.38)(2.51)(0.01)(0.57) Commercial & Industrial Loan Rate Spread0.0090.0150.0010.0120.0150.026 (1.08)(1.48)(0.02)(0.85)(1.01)(1.29) Observations844783504483340300 Adjusted R-squared0.0190.0110.0470.040-0.013-0.014

30 30 Analysis of Bidder Announcement Returns: Interactions (Selected Estimates) Table VII. Panel B. OLS2SLSOLS2SLSOLS2SLSOLS2SLS (1)(2)(3)(4)(5)(6)(7)(8) Escrow Agreement Indicator0.007 * 0.009 0.013 * 0.011 (t-stat)(1.67) (1.00) (1.76) (1.38) Instrumented Escrow Agreement Indicator 0.022 * 0.025 * 0.021 * 0.029 ** (1.80) (1.68) (1.72) (1.96) Target is a Stand-alone Private Firm * Escrow Agreement Indicator0.012 * (1.73) Target is a Stand-alone Private Firm * Instrumented Escrow Agreement Indicator 0.019 * (1.65) Demeaned Relative Size of Target to Acquirer * Escrow Agreement Indicator 0.009 *** (2.62) Demeaned Relative Size of Target to Acquirer * Instrumented Escrow Agreement Indicator 0.005 * (1.70) Top Quintile Earnings Volatility Target Industry * Escrow Agreement Indicator 0.002 ** (2.12) Top Quintile Earnings Volatility Target Industry * Instrumented Escrow Agreement 0.024 (1.37) Low Analyst Coverage Target Industry * Escrow Agreement Indicator 0.014 * (1.81) Low Analyst Coverage Target Industry * Instrumented Escrow Agreement Indicator 0.018 (1.16) Observations844783844783844783844783 Adjusted R-squared0.0180.0100.0180.0130.0170.0140.0180.012

31 31 Implications If both bidders & sellers gain on average by using escrow contracts, shouldn’t all unlisted target acquisitions use it? Potential reasons for why these contracts are not used in all deals: -Sellers who are aware of potential misstatements in reps. and warranties. -Discord among target shareholders with respect to including an escrow. -Sellers with urgent need of liquidity (escrows reduce liquidity). Positive association b/n use of escrow contract & bidder acquisition announcement returns does not imply all bidders should use escrow contract.

32 32 Conclusions -Escrow contracts are commonly used in unlisted target acquisitions. -Used in 52.1% of all unlisted target acquisitions. -Common for stand-alone targets (75.6% of escrows) and stock purchases (80.0% of escrows). -Efficient contracting mechanism, aimed at reducing transaction risk and reducing informational asymmetry and related due diligence costs. -Has important valuation impact on target & increases bidder acquisition announcement returns. -On average, reduces unlisted target discount by 3.5-6.1%.

33 33 We are indebted for proprietary data access by: JP Morgan Escrow Services We recognize use of proprietary data from J.P. Morgan Escrow Services. Kevin Ryan (VP) (Chicago) Daniel Levin (NYC) And for discussions, comments and suggestions by: Greensfelder LLP Joseph Lehrer (Head, Corporate Group) Bryan Cave LLP Bob Newmark (Vice President, St. Louis Office) Acknowledgements

34 34 Post-Deal-Closure Litigation Analysis (Not in Paper) Dependent Variable: Prob. Of Litigation All Targets Deals w/ Escrow Contracts Probit OLS Escrow Agreement Indicator-0.24 *** (t-stat)(6.01) Instrumented Escrow Agreement Indicator -0.76 *** (15.58) Relative Escrow Size -0.042 * (1.76) Indicator for Use of Liability Cap in Acquisition0.060.88 *** 0.019 (1.24)(12.97)(0.53) Indicator for Presence of Dominant Shareholder-0.155 *** 0.86 *** -0.022 (3.81)(10.36)(0.91) Acquisition is Considered an Asset Sale 0.28 *** 0.0020.025 (6.37)(0.03)(0.76) Target is Stand-alone Private Firm-0.96 *** -0.64 *** -0.872 *** (8.78)(5.37)(9.37) Target & Acquirer are in Different Industry0.048-0.0130.022 (1.18)(0.17)(0.92) Target Interest Coverage (scaled by 1,000)-0.051 * -0.59 *** 0.022 (1.74)(8.11)(0.72) Target Accruals0.679 ** 4.91 *** 0.135 (2.55)(9.67)(1.02) Ln (Target Value)-0.035 * -0.407 *** -0.014 (1.71)(9.73)(1.13) (continued) (Show if time permits)

35 35 Post-Deal-Closure Litigation Analysis (Not in Paper) Dependent Variable: Prob. Of Litigation All Targets Deals w/ Escrow Contracts Probit OLS Relative Size of Target to Acquirer 0.087 ** 0.195 *** -0.024 (t-stat)(2.41)(3.48)(1.13) Indicator for Earnout Use-0.26 *** 0.034-0.014 (4.29)(0.38)(0.42) Commercial & Industrial Loan Rate Spread -0.007-0.91 *** 0.016 (1.09)(11.05)(1.0) Top Quintile Earnings Volatility Target Industry Indicator0.015-0.165 ** -0.054 (0.26)(2.26)(1.54) Low Analyst Coverage Target Industry Indicator0.0560.0190.056 (0.93)(0.20)(1.37) Observations826 469 Pseudo R-squared22.9%73.8%- R-squared--76.9% (Show if time permits)

36 36 Claims Post-closing (source: J.P. Morgan Chase Escrow Services, 2009) (Show if time permits)Show if time permits


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